Illiquidity and stock returns: cross-section and time-series effects☆
Introduction
The hypothesis on the relationship between stock return and stock liquidity is that return increases in illiquidity, as proposed by Amihud and Mendelson (1986). The positive return–illiquidity relationship has been examined across stocks in a number of studies. This study examines this relationship over time. It proposes that over time, the ex ante stock excess return is increasing in the expected illiquidity of the stock market.
The illiquidity measure employed here, called ILLIQ, is the daily ratio of absolute stock return to its dollar volume, averaged over some period. It can be interpreted as the daily price response associated with one dollar of trading volume, thus serving as a rough measure of price impact. There are finer and better measures of illiquidity, such as the bid ask spread (quoted or effective), transaction-by-transaction market impact or the probability of information-based trading. These measures, however, require a lot of microstructure data that are not available in many stock markets. And, even when available, the data do not cover very long periods of time. The measure used here enables to construct long time series of illiquidity that are necessary to test the effects over time of illiquidity on ex ante and contemporaneous stock excess return. This would be very hard to do with the finer microstructure measures of illiquidity.
The results show that both across stocks and over time, expected stock returns are an increasing function of expected illiquidity. Across NYSE stocks during 1964–1997, ILLIQ has a positive and highly significant effect on expected return. The new tests here are on the effects over time of market illiquidity on market excess return (stock return in excess of the Treasury bill rate). Stock excess return, traditionally called “risk premium”, has been considered a compensation for risk. This paper proposes that expected stock excess return also reflects compensation for expected market illiquidity, and is thus an increasing function of expected market illiquidity. The results are consistent with this hypothesis. In addition, unexpected market illiquidity lowers contemporaneous stock prices. This is because higher realized illiquidity raises expected illiquidity that in turn raises stock expected returns and lowers stock prices (assuming no relation between corporate cash flows and market liquidity). This hypothesis too is supported by the results. These illiquidity effects are shown to be stronger for small firms’ stocks. This suggests that variations over time in the “size effect”—the excess return on small firms’ stocks—are related to changes in market liquidity over time.
The paper proceeds as follows. Section 2 introduces the illiquidity measure used in this study and employs it in cross-section estimates of expected stock returns as a function of stock illiquidity and other variables. Section 3 presents the time-series tests of the effect of the same measure of illiquidity on ex ante stock excess returns. The section includes tests of the effect of expected and unexpected illiquidity, the effects of these variables for different firm-size portfolios and the effects of expected illiquidity together with the effects of other variables—bonds’ term and default yield premiums—that predict stock returns. Section 4 offers concluding remarks.
Section snippets
Measures of illiquidity
Liquidity is an elusive concept. It is not observed directly but rather has a number of aspects that cannot be captured in a single measure.1 Illiquidity reflects the impact of order flow on price—the discount that a seller concedes or the premium that a buyer pays when executing a market order—that results from adverse selection costs and inventory costs (Amihud and Mendelson, 1980; Glosten and Milgrom, 1985). For standard-size transactions, the
The effect over time of market illiquidity on expected stock excess return
The proposition here is that over time, expected market illiquidity positively affects expected stock excess return (the stock return in excess of Treasury bill rate). This is consistent with the positive cross-sectional relationship between stock return and illiquidity. If investors anticipate higher market illiquidity, they will price stocks so that they generate higher expected return. This suggests that stock excess return, traditionally interpreted as “risk premium,” includes a premium for
Summary and conclusion
This paper presents new tests of the proposition that asset expected returns are increasing in illiquidity. It is known from earlier studies that illiquidity explains differences in expected returns across stocks, a result that is confirmed here. The new tests in this paper propose that over time, market expected illiquidity affects the ex ante stock excess return. This implies that the stock excess return RM−Rf, usually referred to as “risk premium”, also provides compensation for the lower
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I thank Haim Mendelson for valuable suggestions and Viral Acharya for competent research assistance and comments. Helpful comments were received from Michael Brennan, Martin Gruber, Richard Roll, two anonymous referees and Avanidhar Subrahmanyam (the editor).