We study the joint time -series of daily liquidity in bond and stock markets over the Period, 1991 to 1998. We find that spreads and depths in the stock and bond markets are predictable using lagged spreads and lagged orderim balances. Unexpected liqu idity shocks are positively and significantly correlated crosss stock and bond market s , suggesting that liquidity shortages and replenishment sare often systemic innature . During periods of financial crises, the correlation in stoc k and bond spread innovations increases. Monetary policy appears to have an ameliorative e ffect on stock market liquidity during crises. U .S. government bond funds see higher inflows and equity funds see higher outflows during fanancial crises, suggesting a flight to quality during period s of stress .JE LCOD E S: G10, G14, G2 3, and E52
A number of important theorems in Finance rely on the ability of investors to trade any amoun to fasecurity with out affec tin g the price. However, there exists several frictions, such as trading costs, short sale restrictions, circuit breakers, etc. that impact price formation. The influence of mark t imperfections on security pricing has Long been recognized. Liquiity, inparticular, has attracted a lot of atten ion from traders, re glators, exchange o cials as we ll as academics..
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