Essays on liquidity and risk management

This thesis consists of three independent essays on stock liquidity, corporate cash holdings, and financial institution earnings risk. The first study examines the relationship between stock liquidity and the difference in domestic and foreign market prices for a sample of 650 international firms cross-listed on a U.S. stock exchange. The study exploits the 2001 change to decimalization pricing and the 2003 U.S. dividend tax cut as quasi-natural experiments and finds that ADR liquidity decreases the absolute value of the ADR premium. The paper documents a positive relationship between liquidity and price discovery as well as a liquidity effect on the price convergence between the ADRs and their underlying shares. The second study focuses on corporate cash holdings as a mechanism of risk management. The paper documents a diversification effect on cash for a large sample of international firms, and examines the impact of agency costs, financial constraints and product market competition on the relationship between diversification and cash holdings. The results show that weak product market competition can weaken or even reverse the negative diversification effect on cash holdings. Weak country-level shareholder protection helps explain the weak diversification effect to a smaller degree, whereas financial constraints strengthen the diversification effect. Further, the competition effect is stronger for innovative, high R&D intensity firms and for firms with high uncertainty of sales and productivity growth. The third study analyzes the impact of deposit insurance design on the earnings uncertainty of financial cooperatives. The 2008 amendment to the Financial Institutions Act in the province of British Columbia resulted in an economically and statistically significant decrease in the credit unions' earnings uncertainties. The policy spurred deposit growth, but instead of an increase in lending, credit unions grew their capital-to-asset ratio. The results support the hypothesis that an unlimited insurance coverage boosts depositors' confidence and increases the flow of funds to the insured cooperatives. The paper does not find support for the moral hazard hypothesis where full deposit insurance increases risk-taking and creates liquidity risk by attracting wholesale funds.