Investor Sentiment and the Fragility of Liquidity



This paper studies the relationship between investor sentiment and the fragility of liquidity: the property that a small funding shock to the investors’ capital can lead to a large jump in stock illiquidity. I argue that investors’ negative sentiment plays an important role in amplifying the market liquidity impact of funding shocks to investors. Using a vector autoregression (VAR) framework, I find that, given an outflow equivalent to 1% of a stock’s market value, a onestandard-deviation increase in negative sentiment leads to a 33% jump in Amihud illiquidity. In the cross-section of stocks, liquidity is more fragile among stocks which are more sensitive to shifts in investor sentiment. Furthermore, I find economically significant returns for liquidity provision during periods of negative sentiment.

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Sebastian Gryglewicz