Bridge over ocean
1 January 2017 CFA Institute Journal Review

The Impact of Foreign Trades on Emerging Market Liquidity (Digest Summary)

  1. Antony Jackson, CFA

From January 2008 to December 2010, aggressive foreign investor–initiated trades on the Indonesian Stock Exchange aided the price discovery process but increased the degree to which individual stocks’ liquidity tracked overall market liquidity.

How Is This Research Useful to Practitioners?

The Indonesian Stock Exchange (IDX) does not place restrictions on foreign ownership. It also provides publicly available information on whether individual transactions were placed by foreign or domestic investors. Together with Indonesia’s status as a G–20 economy, these factors make the IDX an ideal candidate for research on emerging markets’ microstructure.

Investors in emerging markets are attracted by the diversification those markets offer but are concerned about generally lower levels of liquidity. The authors’ results suggest that from a foreign investor viewpoint, this problem is likely to be exacerbated because the market tends to infer that foreign investors have an informational or information-processing advantage. This inference can lead to domestic investors withdrawing their liquidity in response to “aggressive” foreign investor–initiated trades. Importantly, competitive limit orders with a high chance of being executed are considered aggressive trades.

The authors draw two key conclusions. First, foreign investor–initiated trades improve the price discovery process. Second, foreign investor–initiated trades increase commonality in liquidity, which may be thought of as increasing “systematic” liquidity risk.

The study has important implications for emerging market practitioners, particularly with respect to trading tactics.

How Did the Authors Conduct This Research?

The authors examine trade-level IDX data from 2 January 2008 to 30 December 2010. The IDX is a limit-order market that has no restrictions on foreign ownership. After the authors apply various preprocessing filters, their sample consists of 101 stocks that capture 86% of the stock exchange’s market capitalization.

The authors consider two measures of liquidity—relative bid–ask spreads and market depth—and examine two main questions: whether foreign investor–initiated trades are informative and help drive the price discovery process and whether foreign investor–initiated trades increase commonality in liquidity (systematic liquidity).

Using the information leadership shares concept (developed in prior literature), the authors separate the contributions of domestic and foreign trades to the price discovery process. Their key finding is that aggressive foreign trades—which include competitive limit orders—aid the price discovery process.

An individual firm’s commonality in liquidity is estimated by the R2 of a regression in which the firm’s liquidity is the dependent variable and the independent variables include market-wide liquidity (an average) and such control variables as market returns and volatility.

Subsequent regressions in which commonality in liquidity is the dependent variable are used to estimate the impact of various order types on commonality in liquidity. The authors’ second key finding is that aggressive foreign investor–initiated trades increase commonality in liquidity.

Abstractor’s Viewpoint

The authors exploit the Indonesian Stock Exchange’s openness to foreign investment and the detailed public information the exchange provides. Thus, their results should be viewed as most relevant to emerging markets that are close to the “developed” end of the spectrum.

A key driver of the authors’ results is that the identification of a trader’s origin (domestic or foreign) is public information available to all exchange participants. It is unclear from the paper whether this information is available to market participants in real time. If this information is only available ex post, then to justify the authors’ claim that foreign trades act as some sort of liquidity-adjustment mechanism, market participants must be able to infer the likely identity of the trader via an indirect measure (e.g., trade size).

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