Essays on Financial Market Liquidity under Market Duress

The purpose of this dissertation is to examine financial market liquidity when investors and markets face financial crises. The investigation attempts to discern changes in investor behavior and if evidence exists to support the theory of contagion across markets. Chapter one adds to the literature by examining the dynamics of liquidity and trading behavior patterns during a crisis using transaction level data. Previous studies focus primarily on liquidity during normal trading activity or after corporate news announcements. The primary contribution of this research is to provide answers to questions regarding equity liquidity, investor behavior, and trading activity during a crisis. Internet stocks are selected and categorized based on a quality measure to determine how liquidity changes across quality groups and to determine the direction of investor trading during the crisis. The results are generally mixed. While there is evidence that the crisis had a significant impact on liquidity for both the high quality and low quality groups, the results do not confirm the hypothesis that investors sell their high quality shares in greater numbers during the crisis. The trade direction analysis also does not support the flight-from-quality hypothesis. However, the relationship between liquidity level and returns as suggested by previous studies is confirmed by the data. Chapter two examines the contagion phenomenon during the Asian financial crisis. Contagion has been attributed to shocks that are transmitted through cross-market links as a result of investor reaction. The cross-market linkages result from portfolio investment strategies where funds are invested in several countries within a particular region. When investors begin to lose in one market, wealth declines and investors sell their investments in several markets to compensate and to rebalance risk in their portfolios. This is referred to as investor induced contagion. This process is described in the crisis-contingent literature where liquidity shocks affect investor behavior and in the more recent literature on cross-market rebalancing. Using causality analysis in a vector autoregressive (VAR) framework, this study examines the aggregate liquidity market indices in order to provide another avenue of analysis in determining if contagion is prevalent during a crisis and transmittable through the rebalancing process of international, aggregate investor holdings. The results indicate that market liquidity does not act as an indicator of contagion, and suggest that the market liquidity of developing economies does not lead that of more advanced economies. While the liquidity indices do not reveal any evidence of contagion in the context of this study, the importance of liquidity as a market factor and the study of contagion are not reduced.