Freedom of choice impact on country-specific liquidity commonality

Abstract

We use three facets of freedom of choice (opportunity, decisional autonomy, and immunity from interference) to develop a freedom of choice index for 46 countries and test its impact on commonality in liquidity. We find that the three aspects of individual freedom of choice are negatively related to country-specific market liquidity commonality. Building on Sen’s (1993) theoretical framework, we document that in the presence of opportunities for making independent choices, immunity from encroaching activities, and decisional autonomy, investors tend to show less correlated trading decisions, measured by the levels of liquidity co-movement. To address possible endogeneity bias, we use 9/11 and country-level terrorist attacks as an exogenous source of variations to personal freedom of choice. We find that higher levels of perceived threats in a country restrain personal freedoms and tend to reduce freedom of choice effects on liquidity commonality. Our results are robust to alternative explanations, freedom of choice definitions, and model specifications.

1 Introduction

We study intra-country individual stock market liquidity commonality and analyze differences and causes for idiosyncratic stock liquidity commonality across 46 countries. Liquidity commonality is the degree to which individual stock ‘market liquidity’ co-moves with intra-country aggregate stock market liquidity. We extend the liquidity commonality literature by examining the role of individuals’ freedom of choice on liquidity commonality. We find that all freedom of choice dimensions (individual opportunity, decisional autonomy, and immunity from interference) significantly influence liquidity commonality.

Lower levels of market commonality, as opposed to higher levels of country-specific liquidity commonality, are desirable since higher commonality levels imply not only greater systematic risk (Domowitz et al. 2005; Moshirian et al. 2017; Panagiotou et al. 2023) but also typify markets characterized by the prevalence of groupthink and herding. Independent individual stock market transactions, resulting in reduced liquidity commonality, tend to increase stock market efficiency, facilitate more accurate estimates of true intrinsic stock prices, and result in more efficiently allocated capital.¹

Previous literature suggests that liquidity commonality is primarily driven by correlated supply or demand for liquidity across market participants (Karolyi et al. 2012). Also, a recent study by Moshirian et al. (2017) suggests that liquidity commonality depends on country-specific cultural norms, including behavioral factors; however, the impact of each freedom of choice dimension remains unclear.

Individual stock market-liquidity commonality and individual stock price commonality are related. Eun et al. (2015) and Morck et al. (2013) focus on relationships between cultural individualism and stock price co-movement. In contrast, our study, as well as Moshirian et al. (2017), Dang et al. (2015), and Karolyi et al. (2012) focus explicitly on liquidity commonality. Although price and liquidity co-movements are related (Domowitz et al. 2005), liquidity co-movement and stock price co-movement may result from different market factors.² Specifically, liquidity commonality results from supply and demand co-movements likely due to cross-sectional correlation in order types (market and limit orders), while return commonality is commonly caused by correlation in order flow (order direction and size).

Our fundamental hypothesis is that higher country-specific freedom of choice levels results in lower liquidity commonality levels. Lower liquidity commonality levels may result from investors discounting biased information and relying less on the opinions of others, resulting in higher societal pluralism levels. Thus, we measure these multifaceted impacts on investor decisions by identifying and quantifying country-specific aspects of individual freedom of choice, which include freedom opportunities, decisional autonomy, and immunity for interference for individual decision making. We find that these are critical factors impacting country-specific stock market-liquidity commonality.

Our hypothesis is supported by Morck et al (2000) and Jin and Myers (2006) who find that countries with sound institutional environments and protection from property expropriation, display reduced stock price co-movement. Likewise, we show that personal freedoms are significant factors that reduce individual stock market commonality and for reducing systematic liquidity risk.³

We contribute to the literature by categorizing and quantifying individual aspects of freedom of choice for 46 countries, and documenting that the liquidity commonality is uniquely affected by differences in country-specific individual freedoms of choice. We combine literature threads from behavioral finance fields, behavioral finance, economics, and public policy and show that individual freedoms of choice enrich pluralism and motivate autonomous stock market trading, resulting in decreased country-specific systematic liquidity risk.

Finally, we contribute to existing investor behavior literature by demonstrating that investor perceived freedom of choice increases their incentives to explore and incorporate firm-specific information and discourage correlated trading behavior in the financial market. We find that investors with higher levels of perceived and/or actual freedom of choice increase their incentives to explore and incorporate firm-specific information and discourage correlated trading behavior in the financial market. Our results are robust after controlling various factors of country-specific institutional environment, different proxies for freedom and choice, and alternate model specifications.

The paper is organized as follows: Section II identifies freedom of choice measures and develops hypotheses, Section III covers related literature, Section IV describes Empirical Methodology and Data, Section V presents econometric results, Section VI describes robustness tests, and Section VII concludes.

2 Freedom of choice measures and hypotheses development

We hypothesize that perceived or tangible individual freedoms significantly reduce investor correlated trading behavior and liquidity co-movement. In addition to country-specific cultural differences, we test for other communality determinants, including country-specific governmental policies that facilitate investor diversity of opinion and freedom of press to disseminate unbiased firm-specific news. Correlated transactions, conceivably resulting from herding or institutional factors, indicating undesirable market factors such as restricted, or biased information, stock prices failing to achieve equilibrium or stock prices failing to converge toward true intrinsic values (Sadka and Scherbina 2007). Thus, liquidity commonality, thought to result from correlated stock transactions and biased information, potentially results in stock market mispricing and inefficiency.

We apply three aspects of individual freedom of choice measures as previously proposed by Sen (1993): (i) individual opportunity, (ii) decisional autonomy, (iii) immunity from interference, positing that these measures affect country-specific liquidity commonality.⁴

Several social science studies investigate the role of country-specific respect for individual values on capital markets (Also see: Sen 1999; Friedman 2003; Taylor 2005; Ryan and Deci 2006). Generally, residents of countries with greater opportunity freedoms are more likely to act independently, be actively engaged and productive, generate greater human capital, and foster overall wellness for society (Gough and McGregor 2007; Frey and Stutzer 2010).⁵

The ‘individual opportunity’ aspect of freedom of choice can be proxied by economic freedoms, civil liberties and religious freedoms. It reflects the actual capability of individuals to achieve their objectives and what they value. We identify individual opportunity indices that reflect unique cultural and government policies, measuring the degree to which each country’s citizens have opportunities to choose their own economic actions, civic engagements and religious beliefs.

The literature documents that freedom of religion plays an important role in shaping peoples’ economic behaviors (Guiso et al. 2003). Also, Kumar (2009) and Klein et al. (2017) find that religious affiliation influences individual investor stock selection and security trading patterns. Also, Kumar et al. (2011) show that religion induced effects persist across institutional investors. Following this discussion, we test the following hypothesis:

H1

Freedom of country-specific individual opportunities reduces liquidity commonality.

Our second aspect of freedom of choice is country-specific decisional autonomy. Decisional autonomy is concerned with whether decisions are made by individuals, or rather by other people, groups of people or institutions.

Decisional autonomy–as measured by individualism–has received significant attention in the finance literature. Choi and Nisbett (2000) and Nisbett et al. (2001) find that country-specific individualism levels reduce herding and/or group think. Other studies (e.g., Beckmann et al. 2008; Eun et al. 2015; Moshirian et al. 2017) suggest that individuals residing in cultures stressing individualism, “self-concept” logic, that explains or predicts behaviors reflecting individual rather than group attributes.⁶ These investors are less likely to engage in herding behavior that results in higher levels of stock price co-movements as well as liquidity commonality for traded stocks.

However, a country’s decisional autonomy may not exist if rights to transact freely, without external interferences, are not protected by culture or statute. Therefore, we posit that higher levels of decisional autonomy contributes to societal pluralism, fosters independent decisions, and places less credence on opinions of others. Thus, we test the following hypothesis:

H2

Decisional autonomy reduces intra-country stock market liquidity commonality.

The ‘decisional autonomy’ aspect of freedom of choice is closely related to each country’s relative level of cultural individualism. Cultural individualism reflects reduced herding or groupthink mentality, where individuals are free to make independent decisions relative to their peers. While the majority of the literature focuses on the decisional autonomy aspect of culture, we show that this facet may not exist without the other two aspects of the freedom of choice.

The third aspect of freedom of choice, immunity from interference, is concerned with the extent to which personal decision-making is free or immune from encroachment or interceding of others. In a financial market context, an example of decisional interference may be where the media exerts significant influence on investors’ stock trading decisions (Engelberg and Parsons 2011). Barber and Odean (2008) illustrate an example where individual investors tend to buy attention-grabbing stocks that are in the news. Supporting this aspect, Dougal et al. (2012) observe that WSJ columnist reportings explain 35% of excess Dow Jones Industrial Average returns daily variations. This indicates strong impacts of media coverage on investors behavior and stock performance.

Reuter and Zitzewitz (2006) and Tetlock (2007) offer other examples of media influencing investor financial decisions by providing biased opinions.⁷ Also, Burgess (2010) and Ghoul et al. (2019) opine that a free press, offers diverse and unrestricted perspectives, stimulating open information flows and reduced market commonality.

It should be the responsibility of a country’s media to facilitate investors in making informed decisions by disseminating relevant, accurate and unbiased information (Griffin et al. 2011). If, instead, investors are influenced by biased information, disseminated by state-controlled, corrupt or special interest group media, lacking diversity of content, such information may negatively influence stock market participants. For example, investors in countries characterized by a government-controlled, servile press that censors or distorts information may be enticed to collectively engage in market-wide basket trading instead of exploring firm-specific stock information. Thus, we posit an inverse relationship between a country’s press freedom and stock market liquidity commonality. This leads to our third hypothesis.

H3

Immunity from interference reduces liquidity commonality-co-movement.

We extend the literature in a novel direction by going beyond commonly used cultural variables, such as Hofstede’s individualism. Our analyses include governmental policies aimed to protect economic, civic, and religious individual freedoms, as well as freedom of the press. We quantify these additional aspects of freedom of choice enabling a more comprehensive analysis of the role of freedom of choice in impacting liquidity commonality for each of the 46 countries.

Our study differs from Eun et al. (2015) and Moshirian et al. (2017) in two key aspects. First, both studies focus on the role of the nation’s culture on stock price and liquidity. However, our study centers around the concept of an individual’s freedom of choice instead of the country's national culture or institutional development. Building on Sen’s (1993) framework to quantify different aspects of individual freedom, we document that in the presence of opportunities for making independent choices, immunity from encroaching activities, and decisional autonomy, investors tend to show less correlated trading decisions, measured by the levels of liquidity co-movement.

Second, although Moshirian et al. (2017) provide a comprehensive analysis of different determinants of liquidity commonality, the study was silent on the channel through which cultural dimensions can impact liquidity commonality. In contrast, our study is grounded in the theatrical framework of Sen’s (1993). Our study hypothesizes that higher levels of freedom of choice contribute to societal pluralism, fostering independent decisions, and place less credence on the opinion of others that result in lower levels of liquidity commonality.

Finally, our study not only establishes the relationship between various aspects of the freedom of choice and the commonality of liquidity, but also introduces a novel freedom of choice index. This newly proposed index is designed to comprehensively encapsulate different dimensions of freedom of choice and provides an alternative perspective of the impact the nation’s environment and government policies on individuals’ freedom of choice and their trading behavior in the stock market.

3 Related literature

Previous literature, in the context of stock markets, tends to be inconsistent regarding definitions for freedom of choice and its aspects, impeding clearly identifying freedom of choice impacts on stock market liquidity, liquidity commonality, effectiveness and efficiency. Thus, we more clearly define and quantify freedom of choice.

We contribute to existing investor behavior literature by demonstrating that investor actual and/or perceived freedom of choice increases their incentives to explore and incorporate firm-specific information and discourage correlated trading behavior in the financial market. We find that investors with higher levels of perceived and/or actual freedom of choices increase their incentives to explore and incorporate firm-specific information and discourage correlated trading behavior in the financial market. Our results are robust after controlling various factors of country-specific factors of institutional environment.

We also contribute to the existing investor behavior literature by demonstrating that investor perceived freedom of choice increases their incentives to explore and incorporate firm-specific information and discourages correlated trading behavior in the financial market. Our study provides valuable cross-sectional results on where correlated trading is more prevalent. These results are related to the findings of Barberis and Shleifer (2003), Dorn et al. (2008), Feng and Seasholes (2004), and Sias (2004) who conclude that most investors, including institutional investors, exhibit correlated trading behaviors. Our results are robust after controlling various factors of country-specific factors of institutional environment.

Several additional studies support the prevalence of liquidity commonality/co-movement in both the U.S. and international markets (Chordia et al. 2000; Brockman et al. 2009; Brockman et al. 2023; Dang et al. 2024; Son et al. 2023; and Kamara et al. 2008). Studies implying that liquidity commonality is driven either by liquidity supplier correlated trading include: Brunnermeier and Pedersen (2009), Coughenour and Saad (2004) and Hameed et al. (2010). Other studies imply that liquidity commonality results from correlated trading by stock market liquidity demanders include: Corwin and Lipson (2000), Kamara et al. (2008), Karolyi et al. (2012) and Koch et al. (2016).⁸ Both liquidity supplier and demander explanations focus on the role of correlated trading behavior, albeit emphasizing different roles of liquidity supply versus demand in explaining liquidity commonality.

Brunnermeier and Pedersen (2009), Coughenour and Saad (2004) and Hameed et al. (2010) suggest that funding constraints provide a potential supply-side explanation for liquidity commonality, where, large market declines and/or high levels of uncertainty create illiquidity spirals. Illiquidity spirals may occur if financial intermediaries/market makers are unwilling or unable to supply sufficient liquidity to the market.

Corwin and Lipson (2000), Kamara et al. (2008) and Koch et al. (2016) opine that demand-side liquidity commonality may result from investor groups demanding synchronous market liquidity, either because they receive similar signals or because they follow analogous trading strategies. Both explanations suggest greater liquidity commonality levels, resulting from contemporaneous market buying/selling pressure for same securities.

Some studies, for example Colla and Mele (2010), posit that investors follow correlated trading patterns because they receive similar trading signals, while another body of literature (Engelberg and Parsons 2011; Grinblatt and Keloharju 2001; Guiso et al. 2006) suggests that correlated trading is driven by local cultural biases.

International evidence, including Beckmann et al. (2008), Eun et al. (2015) and Moshirian et al. (2017), find that correlated stock market trading results from impacts of culture aspects, in particular, collectivism versus individualism.

While prior literature supports the role of investor autonomy or Hoftede’s individualism (used as a proxy for culture in prior literature) in reducing liquidity commonality, Sen (1993) argues that investor autonomy may fail to exist if rights to exchange information and transact freely, without external interferences, are unprotected.

We apply economic freedom indices to capture relative degrees that country-specific policies and institutions afford investors with opportunities to implement independent financial decisions. The importance of economic freedoms is supported by Gwartney and Lawson (2003) who reflect on the extent to which country-specific policies support personal choice, voluntary information exchange, free competition, market entry, and protection against external aggression.

Also, previous literature suggests that countries with greater financial markets liberalization are associated with reduced economic contractions and shorter recovery times during periods of financial crises. These studies include: Bjørnskov (2016), higher economic growth levels, Bekaert et al. (2005), financial market liberalization, and Chari and Henry (2004), lower cost of capital. These findings suggest economic freedom enhances the ability of investors to incorporate new, relevant information quickly and efficiently.

We emphasize the impact of diversity of a country’s religious beliefs affecting correlated trading behavior, which is unrelated to impacts of specific religions on investor behavior. We posit that countries with higher religious freedom levels foster independent trading decisions that reduce systematic liquidity risk as measured by liquidity commonality.

Another recent study by Erdem (2020) includes country-specific civil liberties levels, showing that stock markets in countries with greater civil liberties tend to more effectively adapt to the systematic risk associated with the Covid-19 pandemic. Other studies support this finding that countries with greater civil liberty levels demonstrate increased economic development (Benyishay and Betancourt 2010), and cost of debt (Qi et al. 2010).

4 Data and methodology

We define and quantify each facet of freedom of choice by identifying established indices measuring each facet of freedom of choice.

4.1 Individual opportunity

Individual opportunity measures an individual’s prospect of realistically achieving personal goals and objectives. One of these measures is the Fraser Institute Economic Freedom Index, measuring the degree that each country’s policies and institutions support personal choice, voluntary exchange, the freedom to enter and exit markets, the freedom to compete, and the freedom to privately own property.

Also, as a substitute or in combination with the Fraser Institute Economic Freedom Index, we use the Freedom House Civil Liberties Index and Religious Freedom Index from the CIRI Human Rights Data Project.

The Civil Liberties Index assesses each country’s support for individual freedoms of expression and belief, individual rights, associational and organizational rights, and the rule of law.

The Religious Freedom Index reflects the extent to which citizens are free to exercise and practice their religious beliefs without governmental restrictions. These variables used independently or collectively measure a country’s support for individual opportunities that contribute to rich societal diversity and encourage independent investor decisions, resulting in reduce liquidity co-movement.

Economic freedom provides investors with greater personal choices enabling them to incorporate superior firm-specific information in trading decisions. Also, civil liberties reflect individual freedoms to develop independent views, independent institutions, and personal autonomy without government interference. Thus, we posit that countries that legislate and have statutes maintaining and protecting civil liberties, propagate autonomous investors, resulting in independent trading activities and lower liquidity commonality.

The CIRI Human Freedom Data Project’s Religious Freedom Index, measuring the religious freedom aspect of individual opportunity, proxies for the freedom of citizens to practice personal religious beliefs. Although previous studies examine the impact of religious affiliation on corporate risk exposure,⁹ a paucity of awareness exists regarding religious freedom impacts on investor behavior. We observe that religious freedom enriches social pluralism, promotes autonomous trading, thus reducing liquidity commonality. These results support our hypothesis 1.

4.2 Decisional autonomy

Decisional autonomy relates to the extent to which a country exhibits a self-oriented culture and emphasizes individual initiatives as opposed to societal dependence on others or government. Cultural individualism, illustrated by Hofstede (2001), reflects the extent to which individuals focus on their own attributes and make decisions based on their individual knowledge and needs. In such cultures, individuals think and act independently from other people, institutions, and society. Thus, we use the Hofstede (2001) individualism index to assess each country’s’ level of decisional autonomy.¹⁰

4.3 Immunity from interference

Immunity from interference is the extent to which personal decision-making is free or immune from encroachment and/or coercion by others, including government. We quantify country-specific decision interference levels, in terms of financial markets, by adopting the Press Freedom Index from Freedom House that measures media’s influence on investor stock transactions. The Press Freedom Index, beginning in 1980, measures relative international press freedoms.¹¹

Social environments supported by a free press are critical for disseminating reliable, accurate, firm-specific information, resulting in better-informed and independent trading decisions. In contrast, investors in countries served by a servile press most likely are skeptical of perceived unreliable and possibly inaccurate and biased information, thus they are more likely to engage in market-wide basket trading, anticipating that additional diversification may reduce their exposure for individual stock information asymmetry. Basket trading results in correlated demand or supply for liquidity, resulting in a higher liquidity commonality.¹²

4.4 Liquidity commonality measure

For our liquidity measure, we calculate each stock’s Amihud Illiquidity, Amihud (2002), for each of the 46 countries across our study period.¹³

Like Karolyi et al. (2012) and Moshirian et al. (2017), we use the coefficient of determination for least squares regressions, R², as our measure for individual stock liquidity commonality. R² measures the extent to which each stock’s liquidity moves together or displays commonality.

We use daily returns (RI; in local currency) to estimate each stock’s liquidity commonality, R²liq, Other variables are daily trading volume (VO; in thousands of shares), adjusted stock price (P; in local currency), and market capitalizations at the beginning of each calendar year (MV; in U.S. dollars) as control variables, where, data are obtained from DataStream.

Our data include only stock exchanges in each of our selected 46 countries that list the majority of each country’s stock. Depositary receipts (DRs), real estate investment trusts (REITs), preferred stocks, investment funds, and other stocks with special features are excluded from the sample. The sample includes delisted stocks to limit survivorship bias.

Similar to Ince and Porter (2006), daily returns are identified as missing if the total return index value for either the previous or the current day is below 0.01. To deal with non-synchronous trading, non-trading days are identified as the days during which 90% or more of the listed stocks on a given exchange have zero returns. Further, stocks with 80% or more zero-return trading days in each month are excluded from the estimation of R².

Amihud illiquidity is the ratio of daily absolute stock return to dollar volume. Amihud illiquidity, given previous empirical evidence, is strongly and positively correlated with other liquidity proxies, including bid-ask spreads, price impact and fixed trading costs (See: Fong et al. 2017; Goyenko et al. 2009).

Amihud liquidity is calculated as:

$${Liq}_{i,d}= -log \left[1+\frac{\left|{R}_{i,d}\right|}{{P}_{i,d}{VO}_{i,d}}\right]$$

(1)

where Liq_i,d is the Amihud’s measure for stock i on day d, R_i,d is the return in local currency, P_i,d is the price in local currency, and VO_i,d is the trading volume. Amihud measure is multiplied by − 1 to arrive at a variable that is increasing with liquidity.

We account for day of the week liquidity effects by adopting Hameed et al. (2010) filtering regression, for each stock i traded on domestic exchange d, based on observations on day t within each month:

$${Liq}_{i,t,d}={\alpha }_{i,t}^{liq}{Liq}_{i,d,t-1}+\sum_{\tau =1}^{5}{\beta }_{i,t,\tau }^{liq}{D}_{\tau }+{\gamma }_{i,t}^{liq}{HOLI}_{t,d}+{\omega }_{i,t,d}^{liq}$$

(2)

where, ${D}_{\tau } (\tau =1,\dots , 5)$ denotes Monday through Friday day of the week dummies. ${HOLI}_{t,d}$ is a dummy for trading days around non-weekend holidays. Each firm’s lagged liquidity, ${Liq}_{i,t-1,d}$, is included as an independent variable to measure the innovations in daily liquidity.

Using regression residuals, $\omega_{i,t,d}^{liq}$, from Eq. (2), we estimate monthly measures of each stock’s liquidity commonality. We obtain R², our measure of commonality in liquidity, R²liq, is determined from regression parameters resulting from Eq. (3). R²liq, is estimated for each stock, in each country, based on daily observations within each month $m$:

$${\omega }_{i,t,d}^{liq}={\alpha }_{i,t}^{liq}+\sum_{j=-1}^{1}{b}_{i,t,j}^{liq}{\widehat{\omega }}_{m,d,t+j}^{liq}+{\varepsilon }_{i,t,d}^{liq}$$

(3)

where, ${\omega }_{i,t,d}^{liq}$ is the residual from Eq. (2) and ${\widehat{\omega }}_{m,d,t+j}^{liq}$ is the aggregated domestic market residual from Eq. (2) for country of stock i, obtained as the market value (at the end of previous year) weighted average of the residuals for all stocks in the country.

Similar to Chordia et al. (2000) and Coughenour and Saad (2004), we require a minimum of 15 daily observations in a given month to estimate an R² for each stock and to be included when calculating ${\widehat{\omega }}_{m,d,t+j}^{liq}$. Each country’s monthly R² is constructed by equally weighting average R² values across all stocks during each month. As in previous studies, we use R² log transformations, ln [R²/(1-R²)], in our regressions.

Generally, we find that investors residing in countries with relatively higher levels of freedom of choice, lower commonality levels, have higher likelihoods of exhibiting autonomous investment behaviors and lower levels of country-specific systematic liquidity risk.

4.5 Alternative determinants/explanations and control variables

As robustness tests, we examine for the possibility that our results are dependent on our using previously selected explanatory variables. Thus, we test for other possible demand-side and supply-side explanations of liquidity commonality.

Similar to Karolyi et al. (2012), we employ three different supply-side proxies: Market volatility (proxying for market maker funding illiquidity), stock market capitalization to GDP ratios, and total bank deposits to GDP ratios. These measures proxy for each country’s relative level of financial sector maturity and liquidity.

Demand-side liquidity commonality may result from investor groups demanding synchronous market liquidity because they either receive similar signals or because they follow analogous trading strategies. We use is mutual fund equity assets to GDP, foreign institutional ownership to market capitalization, and net percent of equity flows ratios to measure the relative prevalence of institutional investors in each country.

Some studies suggest that investor incentives trade individual stocks rather than baskets of stock, depend on country-specific institutional quality and/or quality of information. For example, both Jin and Myers (2006) and Morck et al. (2000) argue that stock return synchronicity is affected by relative levels of country-specific investor protection and information environment.¹⁴ We control for country-specific investor protection and information quality measures using government effectiveness and political stability estimates from worldwide governance indices, including the International Monetary Fund’s (IMF) Financial Development Index, the Anti-self-Dealing Index from Djankov et al. (2008), each country’s legal origin, and country-specific data whether a country requires International Financial Reporting Standards (IFRS) for publicly traded firms.

Also, we control for each firm’s earning co-movement, industry specific Herfindahl indices, each country’s number of publicly traded stocks in a country, geographical size, GDP growth and GDP per Capita.¹⁵ The standard errors in all our regressions are clustered at the country level. Variable descriptions and data sources are provided in Table 10 in the appendix.

5 Summary statistic and correlation matrix

Table 1 Panel A reports summary statistics from January 1995 through December 2017 for our liquidity commonality measure, R²liq, various freedom of choice measures, and institutional environment. Panel B reports summary statistics for the sample of stocks over the study period.

Table 1 Summary statistics

China has the highest level of liquidity commonality. Other relatively developed countries, Greece, Taiwan and Turkey, also demonstrate higher level of liquidity commonality. Alternatively, developed countries, including the Netherlands, Germany, France, Finland and Norway, demonstrate significantly lower average commonality levels.

China has the lowest freedom of choice index level (-4.35), followed by Pakistan (-3.62) and Russia (-3.43). The USA and Australia exhibit the highest index levels, (2.33) and (2.20), respectively.

Hong Kong and Singapore appear to have the highest ‘individual opportunity’ levels of economic freedom, while Canada, Denmark, and Australia demonstrate extraordinarily high civil liberties and religious freedom levels. The USA and Australia rank highest on ‘decisional autonomy’, as measured by individualism; whereas, Colombia, Indonesia, and Pakistan have the lowest levels. Norway is highest on ‘immunity from interference’, as measured by the press freedom index, whereas, China scores the lowest for both religious freedom and press freedom.

Table 2 reports summary statistics for key control variables, including different proxies for supply and demand-side liquidity commonality and other control variables. Overall, statistics suggest that less-developed countries tend to have higher market volatility levels, lower levels of GDP per capita and smaller stock market capitalization.

Table 2 Summary statistics II

Table 3 presents the correlation matrix for relevant variables. Correlation coefficients between liquidity commonality, R²liq, and some freedom of choice proxies suggest predictive relationships, indicating a negative association between freedom of choice levels and liquidity co-movement. Similar patterns also are reported between country-specific institutional environments and liquidity commonality in univariate relationships.

Table 3 Correlation matrix

6 Results

Table 4 displays key results indicating that freedom of choice measures negatively affects liquidity commonality. Supply-side explanations for commonality are shown in Columns 1–5 and demand-side explanations are shown in Columns 6–10. Independent variables, including proxies for freedom of choice: the Fraser Institute’s Economic Freedom Index, the Freedom House Civil Liberties Index, the CIRI Religious Freedom Index, Hofstede’s culture dimension of individualism and the Freedom House Press Freedom Index are statistically significant and consistent with expected signs. Other control variables that likely explain liquidity commonality are also included. All models control for year fixed effects and include time-invariant country-level variables, including country-specific country geographical size and include time-variant variables, such as the number of traded stocks, which effectively serve as country-level fixed effects.

Table 4 Table measures the freedom of choice effect on liquidity commonality, reporting standardized regression estimates for different freedom of choice proxies on liquidity commonality, including control variables

In summary, we find that all freedom of choice proxies are statistically significant and have negative signs, as expected. Thus, we conclude that freedom of choice proxies, whether used in supply-side or demand-side measures, explain relative liquidity commonality differences across all 46 countries. We further explain these results below.

6.1 Individual opportunity freedom

Results for the individual opportunity proxy imply that liquidity commonality results from lower levels of economic freedom, civil liberties and religious freedom (shown in columns 1–3 and 6–8). Greater individual opportunity contributes to societal pluralism, which fosters independent investment decisions tend to reduce levels of liquidity commonality.

We use the Fraser Institute’s Economic Freedom Index to measure country-specific Economic Freedom, and the Freedom House Civil Liberties Index to measure the impact of civil liberties on liquidity commonality. As posited, we find that both economic freedom and Civil Liberties have negative and statistically significant coefficients, suggesting that both motivate investors to make independent investment decisions, reducing the liquidity commonality.

The negative correlation between the opportunity aspect of freedom of choice and liquidity commonality suggests that countries that promote greater freedom opportunities observe resulting more independent trading activities and lower liquidity commonality. These results support our hypothesis 1.

6.2 Decisional autonomy freedom

Our second aspect of freedom of choice, ‘decisional autonomy’, concerns country-specific degrees of individual autonomy and is measured using the Hofstede (2001) ‘individualism’ index.

Table 4, Columns (4) and (9), summarize regression results for Hofstede’s individualism index. Negative and statistically significant coefficients for individualism are consistent with our narrative that individualistic societies display lower levels of liquidity commonality. These results provide supporting evidence for hypothesis 2 that individualistic societies make independent trading decisions that mitigates systematic co-movement.

6.3 Immunity from interference: press freedom

Negative and statistically significant coefficients for ‘Press freedom’ in Table 4, Columns (5), and (10), suggest a negative correlation between country’s relative immunity from interference, measured by press freedom, and liquidity commonality. Press freedom regression coefficients reflect the impact of each country’s press in facilitating accurate, unrestricted and unbiased information, stimulating diverse individual perspectives. These coefficients are the highest of all variables measuring different aspect of Freedom of Choice for both demand-side and supply-side models. This indicates the dominate role of press freedom plays in liquidity commonality.

Our results are robust to alternative determinants for liquidity commonality when controlling for specific investor groups trading patterns (e.g., mutual funds, foreign institutional traders), market volatility and other proxies of financial market properties. These findings support our hypothesis that immunity from interference reduces liquidity commonality.

In general, our results indicate that the different aspects of freedom of choice reduce systematic liquidity commonality.¹⁶ However, we test for the significance of endogeneity bias that potentially may distort or bias our results and dispute causal relationships. We address endogeneity concerns by identifying exogenous shocks to freedom of choice to validate causal links with systematic liquidity commonality. Endogeneity concerns are later in Sect. 5.5.

6.4 Freedom of choice index: principal components analysis-composite index

Previous results illustrate the importance of all three aspects of freedom of choice; whereas indices used in previous studies tend to focus on a single aspect of freedom of choice. In this section, we apply a principal components analysis to identify country-level orthogonal components/factor of freedom of choice.

Beginning with our data matrix of freedom of choice proxies: the Fraser Institute Economic Freedom Index, the Freedom House Civil Liberties Index, the CIRI Religious Freedom Index, Hofstede’s cultural dimension of individualism and the Freedom House Press Freedom Index, Table 5 identifies the number and identity of orthogonal components/factors that we use to facilitate a country-specific composite freedom of choice index. Determining a unique freedom of choice index for each country enables us to estimate the composite impact of freedom of choice on liquidity commonality.

Table 5 The table presents the regression results of the relationship between the freedom of choice index and liquidity co-movement

Table 5, Panel A, reports that the component one, Economic Freedom, explains 68.8 percent of total variation with an eigenvalue greater than one (eigenvalue of 3.440); whereas all other component eigenvalues are less than one.¹⁷ All freedom of choice factors load highly with the first orthogonal principal component, where Civil Liberties and Press Freedom load the highest. Table 5, Panel B, shows statistically significant and negative coefficients for each country’s unique freedom of choice composite index in explaining liquidity commonality.¹⁸ This is consistent with our hypotheses and previous results.

6.5 Endogeneity tests using personal freedom versus personal safety tradeoffs

We address possible endogeneity bias by assessing how perceived shocks to personal safety impact country-specific freedom of choice proxies and their impacts on liquidity commonality. Previous literature suggests a “sense of threat” may serve as a potential instrumental variable for freedom of choice. During such times, people may trade personal freedoms and civil liberties for greater perceived safety and security (Davis and Silver 2004; Huddy et al. 2005). Thus, to ensure that our results are not driven by spurious correlations or omitted variable, we use the total number of terrorism incidents in each country as an exogenous shock to personal freedom. We use the Global Terrorism Database (GTD) incidences of armed assault, hijacking, and kidnapping in each country as an instrumental variable for exogenous variations freedom of choice variations.¹⁹ We calculate the number of incidents per year in each country by adding the number of armed assaults, hijacking, and kidnapping in each country. We create a variable, “Attacks,” which is defined as the number of incidents per year in each country, scaled by the average annual number of incidents for the entire sample of 46 countries.

Results, summarized in Table 6, Columns (1–6), show negative and statistically significant associations among country freedom of choice proxies and liquidity commonality. The coefficients for interaction terms between country-specific “Attacks” and freedom of choice proxies are positive and statistically significant, except for individualism. This suggests that increases in violent attacks, increases the personal risk, which, in turn, decreases the impact of freedom of choice to reduce liquidity commonality.²⁰ Additionally, coefficients for different aspect of freedom of choice are consistent with previous results, validating that previous results are unaffected by endogeneity.

Table 6 Table adopts country-level terrorism attacks as an instrument as an exogenous variation in the freedom of choice

Table 6 also reports the impact of the September 11, 2001 terrorist attack in the US on liquidity commonality. Prior literature suggests that the 9/11 terrorist attack altered religious freedoms, not only in the USA, but also internationally (Hutcheson et al. 2004; Poynting and Mason 2006). This single unexpected event represents an international exogenous shock to individual freedoms and is a second test for endogeneity bias.

We define “9/11” as a dummy variable that assumes 1 between September 2001 and December 2005 and 0 otherwise. Coefficients for the 9/11 dummy are statistically insignificant, suggesting no effect on liquidity commonality resulting from the 9/11 attacks. However, interaction terms between the 9/11 dummy and the Religious Freedom Index (column 7) and the dummy and the Freedom of Choice Index (column 8) are positive and statistically significant, implying that the impact of both, the religious freedom and the freedom of choice on liquidity commonality was affected during the 9/11 period.

Overall, we find that higher levels of perceived threats in a country restrain personal freedoms and tend to reduce freedom of choice effects on liquidity commonality.

7 Robustness

7.1 Institutional environment, culture and disclosure

A body of literature investigates relationships between institutional environments and financial market development and efficiency (La Porta et al. 2006, 1998, 2000). Prior literature, focusing on co-movement, finds a higher level of firm-level news co-movement in countries with a weaker institutional environment, driving more commonality in stock prices and liquidity (Dang et al. 2015).

To test the robustness of our results, we control for impacts of country-specific institutional environments by using government effectiveness and political stability estimates from Worldwide Governance Indicators (WGI), the Financial Development Index from the International Monetary Fund (IMF) and the Anti-self-dealing Index (Djankov et al. 2008).

Table 7, Columns (1–3) show the regression results.²¹ Though we acknowledge that there is an association between freedom of choice and country-specific institutional environments, results indicate that our findings are not merely a function of each country’s unique institutional infrastructure and market development.

Table 7 The table uses different proxies for the country-specific institutional environment and culture tightness, and reports standardized regression estimates of freedom of choice on liquidity commonality

Table 7, Columns (6–9), includes “Financial disclosure” (Bushman et al. 2004) and “Account score” (La Porta et al. 1998) as additional control variables. Results confirm previous findings and suggest that our findings are not driven by country-specific disclosure requirements.

7.2 2007–2009 Financial crisis

Literature suggest that liquidity commonality tends to be higher during bear markets than bull markets, especially when funding liquidity is tight (Hameed et al. 2010). Thus, we study the period around the 2008 financial crisis by splitting the sample, representing pre- and post-financial crisis periods. The pre-crisis period covers 1995–2007 and the post-crisis period includes 2010–2017.

Table 8 shows larger coefficients for the freedom of choice index during the post-crisis period across different models. This indicates that the freedom of choice index had greater impact on reducing liquidity commonality during the post-crisis period relative to the pre-crisis period. Findings are robust after controlling for the regulatory actions attempting to mitigate economic downturn, central bank and regulatory changes, stock exchange rules and market fragmentation during 2010–2017. This finding is consistent with Cumming et al. (2011) and Jain et al. (2020).

Table 8 The table identifies the pre− financial crisis period 1995–2007 and the post-financial crisis period 2010–2017, reports standardized regression estimates of freedom of choice on liquidity commonality in the pre− and post-financial crisis periods, controlling for different proxies of the country’s institutional environments and culture tightness

7.3 Alternative measure of freedom of choice

It is possible that our previous findings are sensitive to using specific proxies of different facets of freedom of choice. In this case, our results may propose a biased measure of freedom of choice and lead flawed inference about its impact on commonality in liquidity.

We test for robustness of our model using alternative variable/definitions for each aspect of freedom of choice. In this test we use Tang and Koveos (2008) updated version of Hofstede's culture dimension of individualism, the Heritage Foundation’s Economic Freedom Index, the Norris and Inglehart’s Freedom of Religion Index, the CIRI Human Rights Data Project’s Physical Integrity Index and the Freedom of Speech and Press Index.

Results, summarized in Table 9, shows that alterative proxies for freedom of choice yield similar results as those reported in Table 4. Our findings show that commonality is negatively related to all alternative measures of freedom of choice. These findings corroborate our previous findings are suggest that our inference is driven by specific proxies for aspects of freedom of choice.

Table 9 The table uses alternative freedom of choice definitions and reports standardized regression estimates of freedom of choice on liquidity commonality

7.4 Out of sample test, and the impacts of China

We validate previous findings by conducting an out of sample test, using the sample of countries from Karolyi et al. (2012).²² They estimates liquidity commonality for 40 countries for 1995–2009. For brevity, we do not report results for this sample; however, we find consistent results for the impact of different aspects of freedom of choice on liquidity commonality further validating our finding that freedom of choice reduces liquidity commonality and may be generalizable to other samples and time periods.

Since China has an extremely high R²liq of 37% and other countries have an R²liq around 20%, we evaluate the results of this outlier to estimate China’s impact on our findings. To estimate China’s effect on our study, we exclude China from our sample countries and re-test the models. Unreported results confirm a consistent impact of freedom of choice reducing liquidity commonality, even after excluding China.

8 Conclusion

We study the impacts of three aspects of personal freedom of choice (opportunity, decisional autonomy, and immunity from interference) across 46 countries for 1995–2017 on country-specific stock market-liquidity commonality, where, we defined each country’s liquidity commonality as its relative level of individual stock liquidity co-movement. We find that all three aspects of freedom of choice effectively and statistically reduce commonality in liquidity. Further, in the absence one of the aspects of freedom of choice, the presence of the other two aspects of freedom of choice tend to mitigate its negative impact and effect on systematic liquidity risk. Hence, our study looks beyond each aspect of personal freedom of choice and demonstrates that all three facets of freedom of choice may work collectively or separately to reduce liquidity commonality and systemic and systematic liquidity risk.

We identify country-specific freedom of choice indices for each aspect of freedom of choice and estimate their singular and joint impacts on liquidity commonality for major stock markets in each of 46 countries.

Aspects of freedom of choice include: the ‘individual opportunity’, represented by economic freedom, religious freedom and civil liberty; ‘decisional autonomy’ proxied by Hofstede’s individualism; and ‘immunity from interference’ captured by the Freedom House Press Freedom Survey. We find that each aspect, both jointly and independently, is a significant determinants of liquidity commonality.

Countries facilitating greater opportunities for citizens and investors to make independent decisions, free of coercion, without nullifying outside influences, countries that protect/legislate greater levels of personal decisional autonomy and immunity from interference through free press, experience significantly lower liquidity commonality.

Each freedom of choice aspect impact liquidity commonality in each of the 46 countries. We observe that government policies facilitating individual opportunities, individual autonomy, press freedom (reliable sources of information) and religious freedom improve stock market efficiency and liquidity.

Results are robust with respect to alternate model specifications, endogeneity, and alternate freedom of choice measures, including both supply-side and demand-side explanations, and country-specific institutional, accounting and financial environments explanations for stock liquidity commonality.

Appendix

See Table 10.

Table 10 Variables definition