Asset Liquidity and Stock Liquidity

Abstract

We study the balance sheet of liquidity: the relation between the liquidity of the firm's assets and the liquidity of financial claims on the assets, thereby linking corporate finance decisions to stock liquidity. Our model highlights an ambiguous relationship. While greater asset liquidity reduces uncertainty regarding valuation of assets-in-place, it increases future investments and the associated uncertainty. The model shows that asset liquidity improves stock liquidity more for firms which are less likely to reinvest their liquid assets, i.e., firms with less growth opportunities and financially constrained firms. Empirically, we find a positive and economically large relation between asset liquidity and stock liquidity. Consistent with our model, the relation is stronger for firms with low growth opportunities and for financially constrained firms. The relation between asset liquidity and stock liquidity that we uncover sheds new light on the importance of financial frictions for firm investment policy, the tendency of managers to overinvest, and on the value of holding liquid assets.