The returns of short-term reversal strategies in equity markets can be interpreted as a proxy for the returns from liquidity provision. Analysis of reversal strategies shows that the expected return from liquidity provision is strongly time-varying and highly predictable with the VIX index. Expected returns and conditional Sharpe Ratios increase enormously along with the VIX during times of financial market turmoil, such as the financial crisis 2007-09. Even reversal strategies formed from industry portfolios (which do not yield high returns unconditionally) produce high rates of return and high Sharpe Ratios during times of high VIX. The results point to withdrawal of liquidity supply, and an associated increase in the expected returns from liquidity provision, as a main driver behind the evaporation of liquidity during times of financial market turmoil, consistent with theories of liquidity provision by financially constrained intermediaries.
I thank Miguel Ferreira, Terrence Hendershott, David Hirshleifer, Charles Jones, Ron Kaniel, Ian Martin, Konstantin Milbradt, Laura Starks, Dimitry Vayanos, an anonymous referee, and seminar participants at the University of Amsterdam, University of Arizona, University of British Columbia, Columbia University, Federal Reserve Bank of New York, University of Maastricht, Princeton, Rice, Stanford, the American Finance Association Meetings, the NBER Summer Institute, and the Gutmann Center Symposium at WU Vienna for useful comments. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research.