Illiquidity and Closed-End Country Fund Discounts∗

Abstract

In a simple model of segmented markets and exogenous liquidity shock, the closed-end country fund premium is negatively affected by the illiquidity in the host market where shares of the country fund are traded, and positively by the illiquidity in the home market where the underlying assets are traded. To the extent that expected and unexpected liquidity affects asset prices and returns, the closed-end country fund premium should reflect the difference between the illiquidity of the fund shares and its underlying assets. Using the Amihud measure of illiq-uidity, we examine the model prediction for U.S.-traded single country closed-end funds, and find a strong association between the fund premium and illiquidity in both the host and the home markets. Moreover, this relation is much stronger for funds investing in emerging markets where market segmentation is more likely to be binding. These funds are also more sensitive to the systematic liquidity factor, providing additional evidence that the country fund premium may be partially explained by the liquidity risk premium. Financial assets with similar or even the same payoffs can often have different liquidity. Since liquidity is a key feature of the capital market and the macroeconomic environment, an important question to ask is how liquidity affects asset prices. This paper tries to answer that question by investigating whether the fluctuation in the closed-end country fund (CEF) premium is related to liquidity over time. Both the theoretical and empirical aspects of the interaction between liquidity and asset prices have been studied extensively. In a theoretical model that formally relates asset prices to liquidity, Kyle (1985) shows that the asset price is negatively related to a measure of market " depth " known as Kyle's lambda. Allen and Gale (1996) argue that the illiquid asset's price is given by the smaller amount of the asset's long-term fundamental value and the amount determined by the supply and demand of cash (liquidity). 1 There is also extensive empirical evidence that liquidity affects asset prices. The positive return-illiquidity relation across different stocks has been documented in studies this relation over time and confirms that the expected excess stock return increases with the expected but decreases with the unexpected illiquidity in the stock market. Pastor and Stambaugh (2003), on the other hand, find that expected stock returns are significantly related to liquidity betas and provide evidence that liquidity is a priced state variable. 2 Since liquidity matters for …

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Cite this paper

@inproceedings{Jain2004IlliquidityAC, title={Illiquidity and Closed-End Country Fund Discounts∗}, author={Ravi Jain and Yihong Xia and Matthew Qianli Wu and Yakov Amihud and Marshall E. Blume and Michael J. Brennan and Justin S. P. Chan and J. Jay Choi and Karen Lewis and Francis A. Longstaff and Sehyun Yoo}, year={2004} }