The real effects of stock market liquidity

Abstract

One important line of literature in finance studies the real effects of stock market on the economy. Following this area of research, I investigate whether stock market liquidity can affect firm’s real economic activities. This thesis consists of two empirical studies about the effects of stock market liquidity on firm’s default risk and manager’s earnings manipulation.

The first chapter examines the impact of stock liquidity on firm default risk. Default occurs when a firm’s cash flows are insufficient to cover its debt service costs and principal payments. I show that firms with more liquid stocks have lower default risk. Using the Securities and Exchange Commission’s decimalization regulation as a shock to stock market liquidity, I establish that enhanced stock liquidity causally decreases default risk. Then I find two mechanisms through which liquidity reduces firm default risk: through improving stock price informational efficiency, and facilitating corporate governance by blockholders. Of the two mechanisms, informational efficiency channel has higher explanatory power than the corporate governance channel.

The second chapter studies the relationship between stock market liquidity and earnings management. Earning management occurs when managers exercise their discretions over the choices of accounting methods or operational activities with the objective to influence the reported earnings. Using a sample of U.S. public firms over the time period from 1993 to 2012, I find that firms with more liquid stocks have lower level of both real and accrual-based earnings management. The result is robust to the use of various measures of liquidity. I address the endogeneity problem by using instrumental variable approach and a source of exogenous shocks to stock liquidity, i.e. Decimalization regulation. These methods provide evidence of a causal effect of liquidity on earnings management. I further find that liquidity curbs earnings management by mitigating the information asymmetry between managers and shareholder and facilitating governance by large institutional investors.