Demand and Supply and Their Relationship to Liquidity: Evidence from the S&P 500 Change to Free Float

In the context of the switch to free-float weighting in the S&P 500 Index, this study of the effect of the availability of shares on liquidity in the medium term found cross-sectional differences in liquidity and price impact measures that gradually narrowed following each phase of the free-float adjustment. The authors showed how the availability of shares affects stock liquidity in the medium term. The two-step change to a free-float weighting in the S&P 500 Index provides a natural experiment for measuring liquidity dynamics. Prior to the adjustment, some stocks may have had difficulty absorbing demand because of a limited supply of shares, which may have had adverse affects on liquidity. The authors estimated price impact and liquidity measures for three periods between the two index calculation alterations. They examined periods away from actual changes to lessen the impact of short-term price pressure and to focus on longer-term liquidity differences.The authors found cross-sectional evidence of liquidity differences between stocks in the S&P 500 segregated by their free-float factors (or investable weight factors). They showed a gradual narrowing of the liquidity differences between high- and low-free-float stocks following each phase of the free-float adjustment. These findings suggest that the liquidity of constituent stocks can be influenced when the proportion of shares demanded by index funds is inconsistent with the availability of shares for trading.This study provides evidence that liquidity differences are related to the supply of shares. This simple explanation appears to contradict the EMH, which holds that information alone drives stock prices. Although short-term price pressure has been documented in the literature, this study is the first to measure medium-term supply-and-demand effects. This finding implies that demand and supply may influence pricing mechanisms, and if liquidity reflects demand and supply, this finding gives support to a liquidity component in asset pricing.Another implication of this study is that measurement of liquidity should consider the intrinsic trading ability of a stock. Traditional measures of liquidity may be oversimplified, and without controlling for fundamental differences in supply, any conclusions about liquidity differences may become confounded. A third implication of this study is that the prior findings of studies on S&P 500 changes did not consider the availability of shares for trading (free float) before dismissing the liquidity hypothesis. All these implications suggest avenues for further research.