Daily Herding and Commonality in Liquidity on a Pure Limit Order Book Market

Matthew Edgara, Petko S Kalevb, Charly Sujotoa and Robert W Faffc

ABSTRACT
Pervasive herding may cause homogenous trading patterns, both within and across stocks and thus may impact upon an important aspect of the market microstructure liquidity. Potentially, herding could simultaneously affect the liquidity of both individual stocks and that of the market. For this reason, herding is investigated as a potential cause of commonality in liquidity a term which expresses the idea that the liquidity of individual stocks may have common determinants. We find strong evidence of commonality in liquidity in what is the first study of this phenomenon since the ASX adopted anonymous trading. The evidence with regards to the connection between herding and commonality in liquidity, however, is mixed. The results suggest that further work needs to be done to fully understand the relation between these two phenomena.

JEL Classification: G12, G14 Keywords: Herding; Limit Order Book; Commonality in liquidity;

ANZ, Australia. School of Commerce, Division of Business, University of South Australia, Australia c University of Queensland Business School, University of Queensland, Australia
b

*Corresponding author: Petko S. Kalev, School of Commerce, Division of Business, University of South Australia, City West Campus, GPO Box 2471, Adelaide, South Australia 5001, Australia; tel. +61 8 8302 7122; fax +61 8 8302 0992; e-mail petko.kalev@unisa.edu.au.

Electronic copy available at: http://ssrn.com/abstract=1917148

1. Introduction
The market microstructure literature continues to focus significant attention on the comovement of individual stock liquidity with the liquidity of the market, or commonality in liquidity (recent studies include Brockman & Chung, 2008; Chordia, Roll, & Subrahmanyam, 2008; Korajczyk & Sadka, 2008). This phenomenon, also referred to as CL in this paper, was first explored by Chordia, Roll and Subrahmanyam (2000). Commonality in liquidity has clearly been investigated in the context of numerous markets and time periods, and while its existence has been regularly demonstrated, the determinants of CL remain largely unexplored.

In the seminal study, Chordia et al. (2000) suggest that two factors which could logically contribute to CL are market makers (due to the large influence they have on the liquidity of the market), and inventory risk (which is implicit in the role of market markers). However, these determinants fundamentally relate to quote-driven markets. Therefore, they cannot explain the strong results of the numerous studies of CL in order driven markets (Brockman & Chung, 2002; Sujoto, Kalev, & Faff, 2008). The findings of studies from order-driven markets raise doubts about the determinants proposed by Chordia et al. (2000), and suggest that the true causes of liquidity co-movement are yet to be found.

This gap in the literature motivates us to determine whether herding whereby many investors make similar trades in a stock in rapid succession drives commonality in liquidity. This relation is alluded to, although not stated explicitly, by Chordia et al. (2000) who 2

Electronic copy available at: http://ssrn.com/abstract=1917148

hypothesise that the correlated trading patterns of investors with similar investing styles may cause liquidity co-movement. Such behaviour is likely to occur if herding is pervasive in a given market. That is, herding could logically have a significant impact on the liquidity of both individual stocks and the market as a whole, and thus cause commonality in liquidity.

In order to investigate the possibility of a relation between herding and commonality in liquidity, we first follow the methodology established by Chordia et al. (2000) (henceforth the CRS model). This test for commonality in liquidity on the Australian Stock Exchange (ASX) is the first using data from a period following the exchanges decision to shift to anonymous trading in 2005. Therefore, this study becomes the only evidence on CL on the ASX under the markets current architecture. The core objective of the study is achieved by building on the herding study of Edgar, Kalev, Sujoto & Faff (2009). To investigate the hypothesis that herding is a determinant of CL, the CRS model is adapted in a unique fashion, whereby the daily herding time series created by Edgar et al. (2009) is added to the CRS model utilising an interactive variable.

The results of the initial study of commonality in liquidity demonstrate that CL is still a significant characteristic of the ASX during the sample period. However, testing for the relation between herding and CL provides only mixed evidence of a relation between these two phenomena. A number of the stocks in the sample demonstrate strong evidence of the hypothesised positive relation between herding and CL. However, many other stocks demonstrate a strong negative relation and even more show no significant relation at all. The results ultimately suggest that further work is needed to judge whether herding is a determinant of CL, and what type of relation. 3

Electronic copy available at: http://ssrn.com/abstract=1917148

The remainder of the paper is organised as follows. The next section summarises the phenomena of herding and will also briefly review the prior literature on commonality in liquidity. Section 3 describes the data to be used in the analysis, as well as the sample selection and filtering criteria. Section 4 explains the methodology which will be used to test the hypothesis, and Section 5 presents the results of the study and discusses their implications. Finally, Section 6 concludes.

2. Background Literature
2.1 Literature on Herding
Lakonishok, Shleifer and Vishny (1992) (henceforth LSV) is the seminal empirical study of herding by pension funds and the impact that herding has on stock prices. In this paper, LSV focus on the investment behaviour of 769 funds managers in the United States between 1985 and 1989. LSV measure whether quarterly changes in the holdings of individual stocks are correlated across these funds. The results suggest that the funds have an average bias of 2.7% towards either buying or selling a particular stock. In addition, small stocks (6.1%) show a greater average level of herding than large stocks (1.6%).

Following LSVs seminal paper, the herding literature continues to focus largely on testing for herding amongst mutual and pension funds, with numerous studies finding moderate but ultimately underwhelming evidence of herding in the U.S. (Grinblatt, Titman, & Wermers, 1995; Wermers, 1999). More recent studies of mutual funds operating on the mature 4

European stock exchanges have provided similar evidence, with moderate evidence of herding documented in both the U.K (Wylie, 2005) and Germany (Walter & Weber, 2006). The prior literature has also revealed that, on average, herding appears to be more prevalent in developing nations. For example, Voronkova and Bohl (2005) report a herding figure of more than 20% amongst Polish pension funds, while Chang, Cheng & Khorana (2000) demonstrate that herding is substantially more prevalent in the emerging markets of South Korea and Taiwan than in Japan, the U.S. or Hong Kong. Gou and Shih (2008) also find significant evidence of herding in the Taiwanese market.

The vast majority of prior studies, including all those discussed above, have used quarterly or monthly data when testing for the prevalence of herding. The study of Edgar, Kalev, Sujoto & Faff (2009) marks the first attempt to measure market-wide herding on a daily basis. However, there have been some prior studies of daily herding amongst subsets of the market. This is particularly the case with regards to South Korea, where a record is kept of all transactions carried out by foreign investors. Utilising the LSV measure, Kim & Wei (2002) examine the behaviour of four types of investors, over three periods around the time of the Asian financial crisis. Kim & Wei (2002) therefore report twelve separate herding figures, with the results demonstrating a greater level of herding than almost all quarterly studies of the phenomenon (the individual herding results range from less than 1% to over 13%). Hyuk, Bong-Chan & Stulz (1999) also study daily herding using South Korean data, and find very strong evidence of herding, although the results are inflated by the methodology employed.

2.2 Literature on Commonality in Liquidity

The idea that individual microstructure phenomena like liquidity and trading costs may be caused by common underlying factors was first explored by Chordia et al. (2000). In demonstrating that market and industry liquidity were strongly linked to the liquidity of individual stocks on the NYSE, the study became the seminal paper on the phenomenon known as commonality in liquidity. Subsequent studies of CL utilising the CRS methodology have found strong evidence to support these initial findings. The existence of CL has been demonstrated by strong evidence from specialist and dealer markets (Hasbrouck & Seppi, 2001; Huberman & Halka, 2001) and moderate evidence from order-driven markets such as Hong Kong (Brockman & Chung, 2002).

In an Australian context, Fabre and Frino (2004) employ the model of Chorida et al. (2000) to test for liquidity co-movement on the ASX during the 2000 calendar year. The results are ultimately quite weak, which the authors attribute to the absence of dealers on the ASX. However, Sujoto et al. (2008) also utilise the CRS methodology in a study of the ASX over a longer sample period and find far stronger results. Sujoto et al. (2008) suggest that their stronger results may be due to the more stringent filtering criteria applied during the sample selection. Fabre and Frino (2004) restrict the sample to stocks traded at least once every 50 days, while Sujoto et al. (2008) consistent with Chordia et al. (2000) require that a stock be traded at least once every ten days during the sample period. The more stringent filtering criteria applied by Sujoto et al. (2008) results in the sample containing stocks which are (on average) more liquid, and roughly half the number of stocks (333 rather than 660) than that of Fabre and Frino (2004). The highly concentrated nature of the ASX where 80% of the value of trading occurs in the largest 50 stocks leads Sutjoto et al. (2008) to note that the presence 6

of hundreds of illiquid stocks in the sample of Fabre and Frino (2004) could distort the results of the CL regressions. The findings of Sujoto et al. (2008) should thus be considered a more accurate representation of the level of commonality in liquidity on the ASX.

Studies from the developed European markets have also shown strong evidence of commonality in liquidity. For example, Galariotis and Giouvris test for CL on the London Stock Exchange (LSE) between 1996 and 2001. During this period the LSE changed its trading systems from a quote-driven system to order-driven and hybrid systems for the FTSE 100 and FTSE 250 respectively. The study shows strong support for CL on the LSE, but it does not derive a clear conclusion as to which trading regimes are likely to lead to greater systematic liquidity. Kempf and Mayston (2008) study the Frankfurt Stock Exchange using the CRS model, and find significant evidence of CL, especially in the morning, when markets are falling, and for large orders deep into the order book.

As this study examines whether herding could be a potential determinant of CL, it is important to also review the prior literature regarding the causes of CL. In the seminal paper on commonality in liquidity, Chordia et al. (2000) suggest that two factors which could logically contribute to CL are market makers and inventory risk. In addition, Coughenour and Saad (2004) suggest that CL could be caused by information and resource sharing amongst the members of the specialist firms on quote-driven markets, and suggest that this could be a further determinant of CL. However, these factors are only relevant to quote-driven markets, and if these factors did cause CL, one would logically expect the absence of market makers and the lower inventory costs in order-driven markets to lead to less evidence of CL. Alternatively, Brockman and Chung (2002) argue that stocks in order-driven markets will be 7

more vulnerable to commonality in liquidity, as there are no specialists to maintain a moderate level of liquidity in the market. In a more recent study, Brockman and Chung (2008) demonstrate that spread-related CL increases during periods of high market stress in the order-driven Hong Kong Stock Exchange. This result is attributed to the fact that providers of liquidity are free to withdraw their liquidity-provision services. If they choose to do so, a pooling equilibrium of liquidity provision is more likely during a period of market stress, which would consequently lead to greater CL.

3. Data
3.1 Outline of the Data
In order to test for a relation between commonality in liquidity, transaction data is obtained from SIRCA. This data contains the nearest bid and ask quote that precedes each transaction on the ASX and the depth (number of shares available to buy/sell) in the limit order book at the given bid and ask quote. Testing for commonality in liquidity is complicated by the fact that liquidity is not directly observable and, is multi-dimensional. Therefore, liquidity must be measured using a proxy. The prior liquidity literature suggests a number of liquidity proxies, of which we utilise three: the quoted spread, the proportional quoted spread and the quoted depth. The definitions of these liquidity proxies are presented in Panel A of Table 1, along with an explanation of how they are obtained. The SIRCA data are used to calculate the liquidity measures. This is first performed at the transaction level, after which the proxies are averaged to create a daily time series of each proxy for each stock. Finally, the herding data

obtained is a time series of daily stock-specific herding values, utilised in a prior study of herding (Edgar et al., 2009).1 [INSERT TABLE 1 ABOUT HERE]

3.2 Sample Selection

In the herding study of Edgar et al. (2009), the sample consists of 238 firms.2 However, the commonality in liquidity analysis requires some additional filtering beyond that used in the study of herding. Importantly, the effects of changes in tick size need to be accounted for, as these can conceivably alter liquidity patterns. Following the decision by the ASX in 2005 to reduce the tick size for stocks between $0.50 and $2 from 1 cent to 0.5 cent, the maximum tick size now applies to stocks priced above $2 (ASX, 2005). Therefore, to be consistent with the prior CL literature, the current study deletes a stock on any days where its price falls below $2, ensuring a consistent tick size throughout the sample period. Any stock which does not trade above $2 for at least 20 percent of the days in the sample period is then also removed to ensure the regressions are performed on an adequate number of observations. This requirement leads to the removal of a further 67 stocks from the sample, resulting in a sample of 171 stocks.

3.3 Summary Statistics

Panel B of Table 1 reports cross-sectional descriptive statistics for the liquidity proxies which are used in the current study (as described in Table 1). The summary statistics demonstrate that the sample is relatively consistent with those used in previous studies of commonality in
1

For more detail on the herding data, please see Edgar et al. (2009) which explains the data used to create the daily time series of herding values for each stock. 2 For a detailed explanation of the filtering criteria for the herding sample, please see Edgar et al. (2009).

liquidity (Chordia et al. (2000), Fabre and Frino (2004) and Sujoto et al. (2008)). The liquidity proxies are left-skewed, which is usual for this type of data. The major difference from past studies is that the mean and median spread measures are consistently lower than has been documented in prior CL research. The mean of QSPR and PQSPR in this study are 0.0233 and 0.0047 respectively. These are far lower than those reported by Chordia et al. (2000), who report mean QSPR and PQSPR of 0.3162 and 0.0160 respectively, and those of Sujoto et al. (2008), who document mean QSPR and PQSPR of 0.3162 and 0.0160 respectively. The mean DEPTH in this study (21,066) is also quite different to that reported in prior studies. The mean depth is substantially larger than that of Chordia et al. (2000) (3,776), but quite a bit lower than the figure reported by Sujoto et al. (2008) (37,318). These differences can most likely be attributed to the sample restrictions of the herding study, which result in the use of a smaller number of more liquid stocks than prior studies of CL.

4. Research Design and Methodology

4.1 Testing for Herding
As herding is not a directly observable phenomenon, testing must be done via a proxy. The herding data used in this study was calculated using the measure established by Lakonishok et al. (1992). The herding variable is based on the original LSV measure, but is modified to capture herding at daily intervals. The daily herding time-series is developed as follows:

(1)

10

where Bt(i) is the number of brokers who were net buyers of stock i on the given day, St(i) is the number of brokers who were net sellers of stock i on the given day, and Nt(i) is the number of brokers who bought and sold stock i equally on the given day. Additionally, p(t) is the expected proportion of brokers buying relative to the number who were active, based on the market-wide weight of trading and AFt(i) is the adjustment factor and is equal to the expected value of |Bt(i)/(Bt(i) + St(i) + Nt(i)) - p(t)| when there is no herding.3

4.2 Testing for Commonality in Liquidity

In the initial testing for CL, the method of Chordia et al. (2000) is closely followed. This method uses market model setup to test for commonality in liquidity over the sample period. For all individual stocks in the sample, the daily percentage change in each of the liquidity proxies in are regressed on the percentage change in the liquidity of the market (as measured by the same liquidity proxy). When calculating each market liquidity proxy DLM,t, the particular stock i being examined is excluded, resulting in a slightly different explanatory variable for each regression. The CRS model will be employed to test for CL on the ASX, and the regressions are run as follows: ,

(2)

where DLi,t is the percentage change in stock is liquidity proxy from t-1 to t, and DLM,t is the contemporaneous change in the cross-sectional market average of the same liquidity proxy. One lead and one lag of the average market liquidity (DLM,t-1 and DLM,t+1) are included in the

For a more detailed discussion of the herding measure, please see Edgar et al. (2009).

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model to capture any lagged adjustment in liquidity co-movement. Each individual i thus captures the direction and magnitude of the co-movement between the change in liquidity of stock i and the change in the liquidity of the market.

Consistent with the methodology employed by Chordia et al. (2000), a number of control variables are also included in the regressions. Firstly, the concurrent, lead and lagged market return are added to the model to control for any spurious dependence caused by a correlation between the liquidity measures and market returns. Secondly, the contemporaneous change in the individual stocks squared return is included as a proxy for volatility, which could also have a contaminating effect on the liquidity variables. The control variables are generally insignificant and therefore, consistent with prior studies, they are not reported.

4.3 Testing for the Relation between Herding & Commonality in Liquidity
If herding is one of the reasons that individual stock liquidity co-moves with the liquidity of the market, then herding should have some explanatory power for the liquidity beta 1,i. Therefore, setting aside all other determinants of commonality in liquidity, the idea the herding drives commonality in liquidity can be expressed as follows: .

(3)

To test for the relation between herding and CL,

is substituted into the original CRS

model (Equation 2). With some basic rearranging, this yields:

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(4)

where all terms are the same as for Equation 4, with the addition of HERDi,t which is the daily time series of herding values calculated using Equation 1. The key variable of interest is i which is the coefficient on the interactive term that captures the relation between herding and commonality in liquidity. A significant value for i will demonstrate that herding is indeed one of the determinants of commonality in liquidity on the ASX.

5. Results
5.1 Commonality in Liquidity Results
Before investigating the relation between herding and commonality in liquidity, it is first important to conduct a brief examination of commonality in liquidity using the original CRS framework, in conjunction with our new Australian data. These results are presented in Table 2, and demonstrate that there is significant evidence of commonality in liquidity on the ASX during the sample period. For example, the average co-efficient of the contemporaneous liquidity beta for the quoted spread (DQSPR) is 0.460, while that of the proportional quoted spread (DPQSPR) is 0.520. Both co-efficients are highly significant. The average coefficient on the depth variable (DDEPTH), at 0.196, is not as large, but is still accompanied by a highly-significant t-statistic of 12.87. These results are broadly in line with prior studies, and support the existence of commonality in liquidity on the ASX. [INSERT TABLE 2 ABOUT HERE]

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These results, from the order-driven ASX, are slightly lower than those found in prior studies of quote-driven markets (eg. Chordia et al., 2000). This is to be expected, however, as studies of order-driven markets tend to find coefficients of lower magnitude than studies of quotedriven markets.4 Our results are similar to those found in studies of the order-driven Hong Kong Stock Exchange (Brockman & Chung, 2002). The results are also stronger than comparable prior Australian studies (Sujoto et al., 2008) which is most likely due to the omission of the less liquid ASX stocks from our sample to allow for the herding study.

Given that the liquidity coefficients are aggregated across the entire sample, Table 2 also reports the proportion of individual stocks liquidity betas which display the hypothesised positive relationship between individual stock liquidity movement and market liquidity movement, and how many of these are significant. For both DQSPR and DPQSPR, approximately 95% of the liquidity betas are positive, and respectively, 56% and 54% of the liquidity betas are both positive and significant. For the quoted depth, DDEPTH, a large proportion of the coefficients are positive (approximately 86%), however only 22% are positive and significant. We can conclude, therefore, that the liquidity movement of individual firms in terms of either depth or bid-ask spreads is significantly and positively related to market-wide liquidity movement. These results, especially for the spread variables, are very high compared to those in past studies, indicating that commonality liquidity is pervasive amongst this sample of the most liquid ASX stocks. Once again, this is most likely due to our sample consisting of a smaller number of more liquid stocks than most prior studies, which is made necessary by the herding study.

Coughenour and Saad (2004) attribute the higher coefficients found in quote-driven markets to information sharing between specialists.

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Looking at the results in Table 2 in conjunction with the previous Australian studies reveals some characteristics of commonality in liquidity in the Australian market. Firstly, for the spread measures of liquidity, the study finds a higher (and sometimes considerably higher) percentage of significant and positive liquidity betas than in studies of quote-driven markets. At the same time, however, the average coefficients on the liquidity betas are lower in studies of the Australian market. This suggests that although the magnitude of systematic liquidity on the ASX is less than in quote-driven markets, commonality in liquidity may be more widespread in the Australian market. Secondly, despite the overall strength of the findings, studies of the ASX tend to yield far less significant results when using quoted depth as the liquidity proxy. For example, where Chordia et al. (2000) and Brockman and Chung (2002) find average coefficients of 1.373 and 0.438 respectively (with 31% and 38% of individual betas positive and significant), the current study finds a coefficient of 0.196 with 22% positive and significant betas. This finding contributes further evidence to support the suggestion that ASX market participants, on the whole, are more likely to respond to systematic changes in the liquidity of the market by revising their prices rather than the depth or quantity of shares which they are willing to trade (Sujoto et al., 2008).

In most prior studies of CL, the lead and lag terms are usually found to be positive and small in magnitude. However, in Table 2 the average coefficients for the leads and lags are all negative. Additionally, the percentage of positive and significant betas ranges from less than 1% to around 3.5%, which is very low compared to both other Australian studies and international studies, which have found as many as 12% of leads and lags to be positive and significant (Brockman & Chung, 2002; Chordia et al., 2000). This indicates that individual

15

stock liquidity may adjust more rapidly to market liquidity on the ASX than in other markets. Additionally, the higher trading volume of our more liquid sample would naturally be expected to lead to a quicker liquidity adjustment, which would therefore be captured in the contemporaneous liquidity beta rather than in the lag terms.

Finally, the explanatory power of the CL regressions is quite low, with the adjusted Rsquared around 5-6% for the spread measures and 1% for quoted depth. This is typical for studies which utilise the CRS model, which typically finds an average adjusted R-squared measure of less than 5%. Chordia et al. (2000) admit that this is less than impressive, and contribute the low explanatory power to either a large noise component of or other influences on the liquidity constructs of individual stocks. The low R-squared values do not pose a real issue in the context of this study, as the aim is not to find all of the explanatory factors for individual stock liquidity. Rather, the aim of the current study is simply to show that the change in individual stock liquidity co-moves with the change in the liquidity of the market as a whole.

5.2 Relation between Herding & Commonality in Liquidity

Although the prior literature has suggested a positive relation between herding and commonality in liquidity, this hypothesis has never before been tested. Given that the greater homogeneity in trading caused by herding would logically create greater homogeneity in liquidity movement. This hypothesis is tested under a modified CRS framework (as detailed in the Methodology section), and the results are presented in Table 3. [INSERT TABLE 3 ABOUT HERE] 16

The first result of note is that the mean coefficients (gamma in the equation) on the interactive variable (HERDi,t*DLM,t or: the daily herding measure for the given stock, multiplied by the respective liquidity movement variable) are all negative the opposite sign to the hypothesised relation. Additionally, only the coefficient for the DQSPR interactive variable is significant at the 5% level. The DPQSPR interactive variable is significant at the 10% level, while the DDEPTH interactive variable is not significant. As with the commonality in liquidity regressions which directly followed the CRS model, the percentage of positive individual gamma terms, and the percentage of positive and significant gamma terms are presented below their respective mean coefficients. For the interactive terms calculated using the spread measures of liquidity (DQSPR and DPQSPR), approximately 40% and 42% of the individual coefficients are positive, while around 5% are both positive and significant. For the interactive term using the depth proxy for liquidity, around 50% of the individual gammas are positive, but less than 3% are positive and significant. Thus, the results in Table 3 provide an inconclusive answer regarding the relation between commonality in liquidity and herding.

Table 3 also reports the percentage of negative and significant gammas which are found in the individual regressions. The results range from approximately 9% for the interactive variable using the DQSPR measure of liquidity, to around 4% for that using the DDEPTH variable. These findings indicate that although there are slightly more stocks in the sample for which the relation between herding and commonality in liquidity is negative and significant, this difference is not overwhelming.

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In terms of the overall results of the regressions presented in Table 3, a further point of note is that the addition of the interactive herding term to the CRS model did not significantly affect the results of the terms designed to capture commonality in liquidity. The concurrent liquidity betas remain strongly significant, and in fact the mean coefficients have all increased moderately. At the same time, the percentage of individual liquidity betas which are positive and significant have all decreased slightly. The lag terms all yield very similar results to those from the initial CL regressions presented in Table 3. Finally, both the mean and median Adjusted R2 increased slightly (for all three regressions), suggesting that the interactive herding variable adds at least some explanatory power to the model.

The examination of the relation between herding and commonality in liquidity thus leads to inconclusive results it can neither be said to be significantly positive, or significantly negative. At the same time, however, up to 15% of the interactive terms (in the case of the DQSPR regressions) are significant one way or the other. There do not appear to be any characteristics which make a firm to be more likely to exhibit either the hypothesised positive relation between herding and commonality in liquidity or the negative relation. This demonstrates that there certainly is still a possibility that the two phenomena share some connection that is not captured under this methodology.

One potential explanation of the weak results for the relation between herding and CL is the additional requirements of the commonality in liquidity methodology. As the method of Chordia et al. (2000) requires deleting stock-days on which the stocks price falls below $2, 67 stocks are entirely removed from the original herding sample. By definition, many of these stocks are small firms, which are shown to demonstrate the highest propensity for herding 18

(Edgar et al., 2009). A brief examination of this idea (not reported) shows that as herding increases from its lowest levels (stocks with the lowest quintile of herding values), up to the quintile with the second highest level of herding, the average QSPR liquidity beta decreases monotonically. However, the pattern reverses with the quintile which contains the stocks with the highest level of herding. In this top herding quintile the average liquidity beta increases significantly, and a t-test shows that the difference between the liquidity betas in the top two quintiles is significant at the 5% level. This implies that the hypothesised relation between herding and CL may exist only when herding in the stock is extreme.5

5.3 Robustness Testing

Given the original nature of this study, we also perform a number of robustness tests in order to determine whether the relation between herding and commonality in liquidity may be evident under a different specification. The first robustness test performed is to use the same methodology as in Equation 4, but utilise an alternative measure of herding. The alternative measure of herding which is employed is a modified version of the Herfindahl Index, and its value takes the place of HERDi,t in Equation 4.6 The second set of robustness testing explores the idea that there may be a non-linear relation between herding and CL. As the daily time series of herding values and liquidity betas are time-varying the interactive term may need to include a quadratic component. All robustness tests give similar results to those from the original specification,

These results are not reported, but are available upon request. The Herfindahl Index usually measures the concentration of shareholdings in a given stock, and is defined as the sum of the squared holding proportions of the N largest shareholders (Cubbin & Leech, 1983). In the context of this study, however, the Herfindahl index measures the concentration of trading of each stock on the ASX. Thus, the index is calculated as the sum of the squared trading proportions of the N largest brokers (by trading volume on day t) in each stock i.
6

19

yielding no significant relation between herding and commonality in liquidity. The results of the robustness tests are therefore not reported, but are available upon request.

6. Conclusion
The core objective of the current study is to examine the relation between herding and commonality in liquidity, and test for whether these two phenomena exhibit a positive relation. By investigating 171 stocks listed on the ASX, this study provides the first evidence on whether herding drives commonality in liquidity. The OLS regressions, performed utilising a modified liquidity beta framework, provide mixed evidence with regards to this hypothesis. For a small number of the stocks in the sample, the daily level of herding has a significant positive influence on the daily level of commonality in liquidity. However, for an equal or larger number of stocks, the relation is the inverse of the hypothesis that is, for these stocks herding has a strong negative relation with commonality in liquidity. Finally, for the majority of the stocks in the sample, the methodology employed finds little relation between herding and commonality in liquidity. The mixed results from both the core analysis and the robustness tests indicate that additional work is needed in order to fully understand the relation between these two phenomena.

This study also adds to the growing literature on commonality in liquidity on the ASX. The results are significantly stronger than many prior studies of this phenomenon, including both prior Australian studies. These results support the contention that commonality in liquidity is more apparent when testing is carried out over a longer period of time or using a sample which contains more liquid stocks. The results also suggest that the change to an anonymous market system on the ASX has not affected the level of CL which is observed in the market. 20

A number of opportunities for further research in this area remain unexplored. For example, as discussed in Section 5.2, the relation could be explored amongst smaller stocks (below the largest tick size) which are more prone to herding or by only including a stock in the regression on days when its herding value is unusually high or low. A preliminary investigation into this effect in the current study suggests that there may be a stronger relation between the two phenomena amongst stocks with the highest herding values (many of which were excluded due to the tick size requirement). Other potential directions for research in this area could include looking at the relation between herding and CL in other markets, particularly those where trading volume is higher (such as the US markets) or where disclosure requirements are different (such as developing markets).

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Guo, W.-C., & Shih, H.-T. (2008). The co-movement of stock prices, herd behaviour and high-tech mania. Applied Financial Economics, 18(16), 1343-1350. Hasbrouck, J., & Seppi, D. J. (2001). Common factors in prices, order flows, and liquidity. Journal of Financial Economics, 59(3), 383-411. Huberman, G., & Halka, D. (2001). Systematic liquidity. Journal of Financial Research, 24(2), 161. Hyuk, C., Bong-Chan, K., & Stulz, R. M. (1999). Do foreign investors destabilize stock markets? The Korean experience in 1997. Journal of Financial Economics, 54(2), 227-264. Kempf, A., & Mayston, D. (2008). Liquidity commonality beyond best prices. Journal of Financial Research, 31(1), 25-40. Kim, W., & Wei, S.-J. (2002). Foreign portfolio investors before and during a crisis. Journal of International Economics, 56(1), 77-96. Korajczyk, R. A., & Sadka, R. (2008). Pricing the commonality across alternative measures of liquidity. Journal of Financial Economics, 87(1), 45-72. Lakonishok, J., Shleifer, A., & Vishny, R. W. (1992). The impact of institutional trading on stock prices. Journal of Financial Economics, 32(1), 23-43. Sujoto, C., Kalev, P., & Faff, R. (2008). An Examination of Commonality in Liquidity: New Evidence from the Australian Stock Exchange. Studies in Economics and Econometrics, (Forthcoming). Voronkova, S., & Bohl, M. T. (2005). Institutional Traders Behavior in an Emerging Stock Market: Empirical Evidence on Polish Pension Fund Investors. Journal of Business Finance & Accounting, 32(7/8), 1537-1560. Walter, A., & Weber, F. M. (2006). Herding in the German Mutual Fund Industry. European Financial Management, 12(3), 375-406.

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Wermers, R. (1999). Mutual fund herding and the impact on stock prices. Journal of Finance, 54(2), 581. Wylie, S. (2005). Fund Manager Herding: A Test of the Accuracy of Empirical Results Using U.K. Data. Journal of Business, 78(1), 381-403.

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TABLE 1 Liquidity proxy definition and cross-sectional summary statistics

This table contains an explanation of the liquidity proxies which will be used in the testing for commonality in liquidity, as well as summary statistics for the three liquidity proxies. In Panel A, P denotes the price and Q denotes the quantity of shares quoted, while subscripts b, a and m respectively represent the bid, ask and midpoint. The definition, units of measurement and an explanation are listed for each of the three proxies. The liquidity measures are calculated for each transaction throughout the sample period (1st March 2006 - 29th February 2008), and then averaged to create a daily time series for each stock. Panel B presents the summary statistics for the data used in the empirical analysis of commonality in liquidity. These figures are the cross-sectional summary statistics for the three liquidity proxies over the sample period of the current study. To arrive at these statistics, each measure is calculated on a daily basis from the transaction observations for each stock in the sample, creating a daily time series of all three liquidity variables for each stock. The summary statistics are then calculated as the crosssectional statistics of the stock time-series means. Panel A: Liquidity proxy definitions Acronym Definition Units Explanation QSPR is calculated by subtracting the best bid price from the best ask price at each given time PQSPR is calculated by dividing QSPR by the midpoint of the of the bid-ask spread (that is, Pm = (Pa + Pb) / 2) DEPTH is calculated by averaging the depth available on both the bid and ask side at each given time

Quoted Spread

QSPR

Pa - Pb

Proportional Quoted Spread

PQSPR

(Pa - Pb)/ Pm

None

Depth

DEPTH

(Qa + Qb)/ 2

Shares

Panel B: Cross-sectional statistics for time series means of liquidity proxies Mean QSPR PQSPR DEPTH 0.0233 0.0047 21,066 Median 0.0169 0.0035 6,605 Maximum 0.6711 0.1066 6,230,001 Minimum 0.0010 0.0002 105 Standard Deviation 0.0224 0.0046 98,247

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TABLE 2 Market wide commonality in liquidity

This table presents the results of the commonality in liquidity regressions for the 171 stocks in the sample over the sample period of 1st March 2006 - 29th February 2008. The results are based on the regressions of the following equation for each stock:

where DL(i,t) is the percentage change in stock is liquidity measure from trading day t-1 to day t and DL(M,t) is the percentage change in the arithmetic average liquidity for all stocks in the sample, excluding stock i from trading day t-1 to day t . In addition, the lead, lag and concurrent values of the market return and the squared stock return are included as regressors in this equation (coefficients are not reported). The regressions used the White (1980) heteroskedasticity consistent covariance estimator. The coefficients reported are the equally-weighted cross-sectional means of time series slope coefficients, with the corresponding t-statistics in parentheses. SUM = Concurrent+Lag+Lead coefficients. % + reports the percentage of positive slope coefficients, while % + significant gives the percentage of positive slope coefficients with statistics significant at the 5% level (one tailed test). Concurrent %+ % + and significant Lead %+ % + and significant Lag %+ % + and significant SUM Adjusted R-squared mean median DQSPR 0.460 95.32 55.56 -0.036 44.44 2.34 -0.003 40.35 1.75 0.421 0.053 0.040 (10.68) -(0.16) -(1.86) (16.37) DPQSPR 0.520 95.32 53.80 -0.011 52.05 3.51 -0.032 39.77 0.58 0.477 0.065 0.050 (10.43) -(1.79) -(0.49) (16.70) DDEPTH 0.196 85.96 22.22 -0.022 41.52 3.51 -0.025 42.69 2.34 0.149 0.009 0.010 (4.74) -(1.50) -(1.07) (12.87)

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TABLE 3 The relation between herding and commonality in liquidity

This table presents the results of the test for a relation between herding and commonality in liquidity. The results are based on the regressions of the following equation for each of the 171 stocks in the sample, over the sample period of 1st March 2006 - 29th February 2008:

where DL(i,t) is the percentage change in stock is liquidity measure from trading day t-1 to day t and DL(M,t) is the percentage change in the arithmetic average liquidity for all stocks in the sample, excluding stock i from trading day t-1 to day t, and the gamma coefficient (on the interactive variable) captures the relation between herding and commonality in liquidity, as explained in Chapter 5.3. In addition, the lead, lag and concurrent values of the market return and the squared stock return are included as regressors in this equation (coefficients are not reported). The coefficients reported are the equally-weighted cross-sectional means of time series slope coefficients, with the corresponding t-statistics in parentheses. The coefficient on HERD(i,t)*DL(M,t) captures the effect that herding has on commonality in liquidity under each of the regression specifications. SUM = Concurrent+Lag+Lead coefficients. % + reports the percentage of positive slope coefficients, while % +/- significant gives the percentage of positive/negative slope coefficients with statistics significant at the 5% level (one tailed test). The regressions utilised the White (1980) heteroskedasticity consistent covariance estimator. Concurrent %+ % + and significant Lead %+ % + and significant Lag %+ % + and significant SUM HERDi,t*DLM,t %+ % + and significant % - and significant Adjusted R-squared mean median DQSPR 0.510 91.23 47.37 -0.038 45.61 3.51 -0.004 40.94 1.17 0.469 -0.419 40.351 5.848 8.772 0.054 0.050 (10.66) -(2.00) -(0.23) -(1.87) (15.14) DPQSPR 0.562 88.30 39.18 -0.012 53.80 4.68 -0.037 39.77 0.58 0.513 -0.326 42.105 5.263 6.433 0.067 0.050 (9.83) -(1.40) -(2.03) -(0.18) (14.52) DDEPTH 0.204 71.35 12.87 -0.018 41.52 3.51 -0.025 42.11 2.34 0.161 -0.057 50.292 2.924 3.509 0.010 0.000 (3.58) -(0.23) -(0.31) -(0.22) (5.27)

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