Active Liquidity Management, Strategic Complementarities, and Market Price of Liquidity

This paper examines how market uncertainty impacts the liquidity premium through a demand-side channel. I find that equity mutual funds actively increase the liquidity of their portfolios in response to increased redemptions during market stress. Liquidity preservation is more intense for funds more exposed to strategic complementarities. I show that a stock’s relative illiquidity within a fund’s portfolio is a key determinant in flow-induced rebalancing decisions, whereby funds follow a liquidation “pecking order.” This “flight-to-liquidity” is associated with increases in the liquidity premium and affects individual stocks’ reversal performance: Stocks held by more fragile funds and those with higher illiquidity ranks within funds’ portfolios experience greater returns to liquidity provision during market stress. This paper was accepted by Victoria Ivashina, finance. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2022.02095 .