Study On Liquidity Risk Of China's Stock Market

The stock market is full of vitality because of liquidity which is also one of the measures to determine the quality of the market. The improvement in liquidity not only contributes to make the market active and absorb the investors, but also is beneficial to stabilize the market price, guarantee the financial market to operate well and distribute the resources effectively. Moreover, it is proved that liquidity is one of the important deterministic factors of asset price. Based on financial market microstructure, this paper systematically makes the research on liquidity and liquidity risk of China's Shanghai and Shenzhen stock exchange.This paper first constructs a market risk adjusted illiquidity measure which has a high correlation coefficient with the Amihud(2002) illiquidity measure and the correlation coefficient is 0.8444. Taking advantage of this measure to study the liquidity of China's stock market, this paper finds that there is a strong dependence on liquidity between SHSE and SZSE and the correlation coefficient is up to 0.9438; through the comparison on the price impact index, the liquidity of China's stock market is lower than that of other markets; the liquidity of portfolios is increasing on the total market capitalization of them. The market cumulative abnormal illiquidity will drop significantly when the policies which are beneficial to the market are announced and vice versa by means of event study methodology. The government policy can mainly affect the market liquidity through the impact on the supply of funds of the stock market in the medium and long-term and psychological expectations of investors and investor sentiment in the short-term.There exists commonality in liquidity and liquidity risk is of systematic characteristics in China's stock market after the study using the market model and the systematic liquidity risk coefficients decrease in the group liquidity and size; Moreover, based on behavioral financial theory, this paper explains that the cause for systematic liquidity risk formation is the mutual mimetic contagion among investors in sentiment and behavior. The depth and structure of correlation between the systematic liquidity risk and market risk of China's stock exchange can be described by Gumbel Copula and Frank Copula for SHSE and SZSE, respectively after the Copula function studied, which means the correlation between the two risks doesn't enhance in the lower tail of the risk distribution. Based on the study of liquidity risk measurement——LVaR, in comparison with the lower liquidity portfolios there is a smaller temporary impact coefficient, shorter liquidation period and lower liquidation costs LVaR. On the purpose of minimum the liquidation costs, the proportion of average liquidation costs to the initial market capitalization is about 5% for the higher liquidity group, but 7% for the lower liquidity group under the optimal liquidation period. Liquidity risk early warning system is constructed using KLR method and the results tell us there is a greater liquidity risk during 2008-2009 in China's stock market; investors can adjust the portfolios according to the market liquidity, take advantage of the optimal transaction execution strategy and risk hedging instruments to manage the liquidity risk; moreover, institutional investors should avoid the homogenous investment.Finally, this paper puts forward several proposals. For the China's stock market regulators, first, the establishment of risk hedging mechanism should be expedited; second, they should establish the emergency response mechanisms of liquidity risk; and last they should keep the policies stable to prevent large fluctuations in investor sentiment.