Who are Driving Commonality in Liquidity?

Individual stocks co-vary with each other in their liquidity, which induces a systematic, undiversifiable liquidity risk for investors. Despite the pervasive evidence on the commonality in individual liquidity within stock markets, few researches have looked at the source of commonality in liquidity. This study investigates whether correlated trading behavior of institutional investors causes co-variation in their demand of liquidity, and thus co-variation in liquidity. The empirical test using Japanese stock data shows that institutional investors prefer liquid stocks over illiquid stocks, and such preference is especially strong for foreign institutional investors. We also find that stocks heavily traded by institutional investors (both domestic and foreign institutional investors) have a higher commonality in liquidity than stocks heavily traded by individual investors. The positive relation between commonality in liquidity and co-movement in trading activity in stocks suggests that institutional investors’ correlated trading behavior does have some impact on the liquidity risk