Market volatility and stock returns: The role of liquidity providers

• Published in: Journal of financial markets (Amsterdam, Netherlands) Netherlands), 2018-01, Vol.37, p.17-34
• Main Authors: Chung, Kee H., Chuwonganant, Chairat
• Format: Article
• Language: English
• Subjects: Illiquidity premium; Market structure; Risk premium; VIX
• ISSN: 1386-4181; 1878-576X
• DOI: 10.1016/j.finmar.2017.07.002

This study shows that market volatility affects stock returns both directly and indirectly through its impact on liquidity provision. The negative relation between market volatility and stock returns arises not only from greater risk premiums but also greater illiquidity premiums that are associated with higher market volatility. Consistent with our expectation, we also find that stock returns are more sensitive to volatility shocks in the high-frequency trading era, and after the regulatory changes in the U.S. markets that increased competition between public traders and market makers, reduced the tick size, and decreased the role of market makers. •Market volatility affects stock returns both directly and indirectly through its impact on liquidity provision .•The negative relation between market volatility and stock returns arises from greater risk and illiquidity premiums .•Stock returns are more sensitive to volatility shocks in the high-frequency trading era .•Stock returns are more sensitive to volatility shocks when there is greater competition between public traders and market makers ..•Stock returns are more sensitive to volatility shocks when tick size is smaller and the role of market makers is smaller.