The returns of short-term return reversal strategies can be interpreted as
a proxy for the returns from liquidity provision. The returns of these reversal
strategies are highly predictable with the VIX index and strongly time-varying.
In times of financial market turmoil, as indicated by elevated levels of the VIX
index, the expected returns and the conditional Sharpe Ratios from liquidity
provision increase enormously. The results point to withdrawal of liquidity supply,
and an 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 imperfect liquidity provision due to constraints
and pro-cyclical risk-bearing capacity of financial intermediaries.