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Evaporating Liquidity

The returns of short-term return reversal strategies in equity markets can be interpreted as a proxy for the returns from liquidity provision. Analysis of their returns shows that the expected return from liquidity provision is highly time-varying and closely related to the VIX index. Expected returns and conditional Sharpe Ratios increase enormously along with the VIX during times of financial market turmoil, such as the financial crisis 2007-09. This time-variation in the expected returns from liquidity provision is particularly pronounced among high-volatility stocks, indicating flight to quality. The results point to withdrawal of liquidity supply, and an associated increase in the expected returns from liquidity provision, as a main driver behind the evaporation of liquidity during times of financial market turmoil, consistent with theories of liquidity provision by financially constrained intermediaries.s