Flight to liquidity due to heterogeneity in investment horizon

Abstract

Purpose

The purpose of this paper is to provide some rational perspectives for the flight‐to‐liquidity event rather than simply attributing it to the change in investor sentiment.

Design/methodology/approach

The paper builds a model to highlight the inherent difference in investors' investment horizon, and thus their sensitivity to changes in transaction costs in the stock and bond markets. When stock market deterioration results in higher trading costs, the existing marginal investor shifts wealth to bonds instead of remaining indifferent between stocks and bonds. At the new equilibrium, there is a higher fraction of bond ownership and a longer average investment horizon among stock holders. The paper then empirically tests the model predictions using data in the US stock and bond markets.

Findings

The authors find evidence strongly supporting this paper's theoretical predictions. Days with high stock illiquidity, high stock volatility and low stock return are associated with high yield spread in the bond market. This contemporaneous linkage between the stock market and the bond market is even stronger during periods with strong net outflows from stock mutual funds and strong net inflows to money market funds. The paper also demonstrates the existence of a maturity pattern that the predicted effects, especially the effects of stock illiquidity, are much stronger over shorter maturities.

Originality/value

The finding of this model that the investment horizon of the marginal investor (and thus the equilibrium price impact in the bond market) responds to changes in market conditions contributes to the theoretical debate on whether transaction costs matter. The flow evidence strengthens our understanding of the asset pricing implications of portfolio rebalancing decisions, and the maturity effect bolsters the case for flights to liquidity/quality due to heterogeneity in investment horizon without resorting to investor irrationality or behavioral attributes. In fact, it is arguably difficult to reconcile with a behavioral explanation.

Citation

Lei, Q. and Wang, X. (2012), "Flight to liquidity due to heterogeneity in investment horizon", China Finance Review International, Vol. 2 No. 4, pp. 316-350. https://doi.org/10.1108/20441391211252139