Topic 8: Origins of Liquidity and Volatility Solutions

Question 1

Define each of the following dimensions of liquidity:

a) Immediacy
b) Width
c) Depth
d) Resiliency

a) Immediacy is how quickly trades can be arranged at a given cost. This is most
important to traders with specific information or directional views.
b) Width is the cost of trading a certain size of trade, and includes the bid-ask
spread (implicit cost) and explicit costs (like brokerage).
c) Depth refers to the amount of shares that are available at any given price
level.
d) Resiliency is a measure of how quickly prices return to their fundamental level
after large orders are executed on an exchange.

Question 2
Determine which of the following companies is most liquid and give reasons:

a)
I. Hutchinson Telecommunications whose largest shareholder, Hutchinson
Whampoa, owns 85% of the shareholding.
II. BHP whos top 10 shareholders own 43% of the company
III. Metal Storm, whos largest shareholder holds 40% of the company
b)
I. NRMA which has 25,000 shareholders
II. OneSteel which has 5,000 shareholders
III. Vanderfield Holdings, which has 35 shareholders

a) BHP will likely be the most liquid, as the 43% is spread between 10
shareholders, with a remaining Free-Float of 57%. Hutchinson has only got a
free float of 15%, and whilst Metal Storm has 60% held by the non-majority
shareholder, the remaining 9 largest shareholders are likely to hold more than
1%, making it less liquid than BHP.
b) As NRMA has the most shareholders it is likely to be most liquid, however if
OneSteel had a much lower concentration ratio (that is the largest shareholders
were not very big) it could be argued that OneSteel is more liquid.

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Question 3

What is the Volatility Index? How could you interpret a VIX of 12%?

The Volatility Index seeks to track and monitor the volatility of the S&P 500 over
the next 30 days. It is constructed using the prices of all out of the money put and
call options that have expiries in the next two months.
A VIX of 12% implies that in the next month there will be a 3.46% [i.e., 12%/sqrt
(12)] movement in the next 30-day period. As it is based on 1 standard deviation,
it is thus expected that the S&P 500 has a 68% probability of staying within
3.46% of the current price.

Question 4

To which volatility component do the price impacts of news traders contribute? To

which volatility component do the price impacts of value traders contribute?

News traders and value traders both contribute to fundamental volatility as their
actions incorporate new information into prices and move prices to the new correct
levels. Value traders also contribute to lower transitory volatility as their actions
will restore prices to the correct levels when uninformed or liquidity trading cause
prices to move away from the correct asset values.

Question 5

The below print out provides the necessary equations to compute historical
volatility. Based on this information and the sample data below for BHP, what is
the Daily Historical Volatility for BHP?

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 i Date Closing Price (S) ui = LN(Si/Si-1) (ui - u)2
22 2/09/2011 39.04 -2.10% 0.0392%
21 1/09/2011 39.87 0.33% 0.0020%
20 31/08/2011 39.74 0.99% 0.0123%
19 30/08/2011 39.35 0.51% 0.0040%
18 29/08/2011 39.15 1.31% 0.0206%
17 26/08/2011 38.64 0.08% 0.0004%
16 25/08/2011 38.61 1.04% 0.0136%
15 24/08/2011 38.21 0.00% 0.0002%
14 23/08/2011 38.21 1.80% 0.0368%
13 22/08/2011 37.53 0.08% 0.0004%
12 19/08/2011 37.5 -4.18% 0.1645%
11 18/08/2011 39.1 -1.82% 0.0290%
10 17/08/2011 39.82 0.98% 0.0123%
9 16/08/2011 39.43 -1.06% 0.0088%
8 15/08/2011 39.85 4.20% 0.1871%
7 12/08/2011 38.21 0.74% 0.0074%
6 11/08/2011 37.93 -1.23% 0.0123%
5 10/08/2011 38.4 3.58% 0.1370%
4 9/08/2011 37.05 1.22% 0.0181%
3 8/08/2011 36.6 -4.07% 0.1557%
2 5/08/2011 38.12 -4.96% 0.2344%
1 4/08/2011 40.06

u = -0.1228%

= 1.0959%

= 2.34%

h = 252 = 37.16%

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Question 6

The following daily prices were collected for each of three stocks over a 12-day
period. Based on the data in the table to the right, calculate the following:
a) Returns for each day on each of the three stocks.
b) Average daily returns for each of the three stocks
c) Daily return standard deviations for each of the three stocks

Price (a) Daily returns

Date Company X Company Y Company Z Company X Company Y Company Z
9-Jan 50.125 20.000 60.375
10-Jan 50.125 20.000 60.500 0.000000% 0.000000% 0.207039%
11-Jan 50.250 20.125 60.250 0.249377% 0.625000% -0.413223%
12-Jan 50.250 20.250 60.125 0.000000% 0.621118% -0.207469%
13-Jan 50.375 20.375 60.000 0.248756% 0.617284% -0.207900%
14-Jan 50.250 20.375 60.125 -0.248139% 0.000000% 0.208333%
15-Jan 52.250 21.375 62.625 3.980100% 4.907975% 4.158004%
16-Jan 52.375 21.250 60.750 0.239234% -0.584795% -2.994012%
17-Jan 52.250 21.375 60.750 -0.238663% 0.588235% 0.000000%
18-Jan 52.375 21.500 60.875 0.239234% 0.584795% 0.205761%
19-Jan 52.500 21.375 60.875 0.238663% -0.581395% 0.000000%
20-Jan 52.375 21.500 60.875 -0.238095% 0.584795% 0.000000%
(b) Average daily returns = 0.406406% 0.669365% 0.086958%
(c) Daily return standard deviations = 1.203955% 1.484154% 1.629587%

Question 7

Torre Company stock realized a 52-week high of $50 per share and a 52-week low
of $25. What is the Parkinson extreme value estimate for variance for this stock?
What would be the corresponding standard deviation estimate?

Given:

H = 52-week high = $50

L = 52-week low = $25

The Parkinson extreme value estimate for variance is computed as follows:

2p = 0.361 * [ln (H/L)]2

2p = 0.361 * [ln(50/25)]2

2p = 0.173444

The standard deviation (p) is the square root of this value:

p = (0.173444) = 0.416466 (i.e. 41.6%)

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Question 8

What is the difference between historical and implied volatility?
Implied volatilities should be viewed differently from statistical volatilities even
though they both forecast the volatility of the underlying asset over the life of the
option. The two forecasts differ because they use different data and different
models.

Implied methods use current data on market prices of options, so the implied
volatility contains all the forward expectations of investors about the likely future
price path of the underlying. Also, due to the Black & Scholes assumptions this
method assumes that the underlyings price path is continuous.

Contrast this with statistical methods which use historic data on the underlying
asset returns in a discrete time model for the variance of a time series.

Question 9

If an investor believes that realised volatility for the next three months is likely to
be much higher than current implied volatility, should she buy or sell options?

Implied volatility, as discussed before, is the level of volatility implied by current

options prices. Implied volatility and price, for both call and put options, exhibit a
positive relationship higher volatility leads to a higher price.
If an investor expects the market to realise volatility that is above current implied
volatility, then she should purchase options, which are currently under-priced.

Question 10

What does commonality in liquidity refer to?

Please read the attached PDFs in order to address the above question:
FINC3014 Topic8 - ChordiaRoll&Subrahmanyam2000_JFE.pdf
FINC3014 Topic8 - KarolyiLee&Dijk2012_JFE.pdf

These papers expand the literature on market microstructure by examining

liquiditys broader determinants rather than focussing solely on the
microstructure of individual assets, without consideration of their wider market
context.

Commonality in liquidity refers to the systematic patterns in liquidity across

different stocks. Liquidity levels are driven by both these systemic market forces
and certain stock-specific attributes. Liquidity is therefore said to exhibit
correlation/commonality across markets.