Relationship between liquidity risk and stock price

relationship between liquidity risk and stock price

MacBeth regressions, controlling for beta, size, book-to-market and that the relationship between returns and the bid-ask spread shocks could be a .. liquidity as a risk source, while fluctuations in stock-level liquidity have. RELATIONSHIP BETWEEN LIQUIDITY AND RETURN OF STOCK AT. THE NAIROBI .. relation to future returns, countering the pricing of liquidity risk. However. investigate the relationship between share repurchase and stock liquidity value added from market perception, and reduce idiosyncratic risk.

Idiosyncratic Volatility and Liquidity Risk: How they have Explanatory Power in Stock Returns

The remainder of the paper is organised as follows: Section 2 presents the literature review. Section 3 describes the data, the liquidity measure and the portfolio formation procedure. The methodology and results of the asset pricing tests are presented and discussed in Section 4. Finally, Section 5 concludes the paper.

Previous empirical evidence Studies about liquidity primarily concentrated on analysing the impact of individual assets liquidity on returns Amihud and Mendelson, ; Brennan and Subrahmanyam, ; Datar et al.

However, the evidence reported is ambiguous: They document a positive relation between expected return and illiquidity. However, Eleswarapu and Reinganumwho extended the sample period by 10 years, find that the existence of a positive liquidity premium is only limited to January.

Market liquidity - Wikipedia

Nevertheless, it is important to note that these authors consider liquidity as a stock characteristic rather than an aggregate risk factor of concern to investors. The recent relative consensus about the existence of commonality in liquidity raises a new question about the role of liquidity in asset pricing.

Therefore, commonality in liquidity could represent a source of non-diversifiable risk, and, in that case, the sensitivity of an individual stock to liquidity shocks could induce the market to require a higher average return. In their seminal paper, Acharya and Pedersen propose a liquidity-adjusted CAPM LCAPMin which a security required return depends on its expected liquidity, as well as on the co-variances of its own return and liquidity with the market return and liquidity.

Using the Amihud illiquidity ratio and stock returns, these authors find some evidence that illiquidity betas are priced in the USA, and that their model is better than the standard CAPMin terms of goodness of fit. Other authors, such as LeePapavassiliouLi et al.

The empirical evidence presented is supportive of the LCAPM, in which liquidity risks are priced independently of market risk in international financial markets.

In consistent with the findings of Acharya and Pedersen in the USA, these authors also report evidence that the liquidity-adjusted CAPM is superior to standard CAPM but they only obtain weak evidence for the argument that liquidity risk is priced in addition to the liquidity level and the market risk.

The Acharya and Pedersen model was also tested in other developed yet small stock markets, such as Greece and Finland. For the Greek stock market, Papavassiliou provides evidence that liquidity risk is a priced factor, mainly arising from the covariation of individual liquidity with local market liquidity, and that the level of liquidity seems to be an irrelevant variable in asset pricing. Butt and Virk use the proportion of the zero-returns illiquidity measure, in addition to the Amihud illiquidity ratio, to report evidence that a substantial risk premium related to illiquidity risk exists in the Finnish market, and that a liquidity-adjusted CAPM performs better than simple CAPM specifications.

Although this strand of the financial literature is boundless, prior evidence for the Portuguese stock market is scarce.

Investment Tips - Return, Risk and Liquidity

The initial works of Escalda and Mello and Escalda were focused on analysing the role of individual liquidity in asset pricing for a sample period in which the Portuguese market was an emerging market. However, subsequent studies, such as those of Pereira and Cutelo and Miralles-Marcelo et al. More precisely, Pereira and Cutelo observe that low-price stocks are less liquid than high-price stocks and trade at lower valuation ratios. Finally, they argue that their results do not support any of the existing theories on optimal price per share.

On the other hand, Miralles-Marcelo et al. Following the Chordia et al. However, they do not take into account the change froman emerging to a developed market.

In this context, in the present study for the Portuguese stock market, we analyse the effects of liquidity in asset pricing, both as an individual characteristic of financial assets, like the initial studies, and as a source of systematic risk, like more recent studies.

Moreover, we analyse possible changes affected by the evolution of this market into a developed one. Data In this study, we use monthly and daily data for the period from 2 January to 31 Decemberretrieved from Thomson Datastream. The data obtained include the following variables: We select all stocks traded in the Euronext Lisbon Stock Exchange with available data for at least 24 months.

The final sample is composed of different stocks, which were traded during some period of time between and The return of the market portfolio is proxied by the equally-weighted return of all stocks available in each month of the sample. And, as Portugal did not have short-term government securities during most of the period covered by this study, we proxy the risk-free rate of return by the equivalent monthly Interbank Money Market Overnight interest rate.

The merger of the Portuguese stock market with Euronext in did not bring about many fundamental changes. The consolidated Euronext exchange maintained the market structure of the participating exchanges, and the main implication of the unification was to make cross-border trading easier Nielsson, Therefore, it seems important to study the effects of the classification event[2]. The illiquidity measure Following recent evidence for the Portuguese stock market Miralles-Marcelo et al.

As argued by Lesmond et al. So, the occurrence of zero returns can be considered a measure of illiquidity. The biggest advantage of this measure is that it only requires a time series of daily equity returns.

Moreover, Bekaert et al. Table I presents summary statistics for this illiquidity measure for the entire sample period and for two subsample periods: During the entire sample period, the average ZR is As expected, in the emerging market sample period the average illiquidity is higher than in the period after the classification as a developed stock market. Actually, ZR average is Monthly aggregated illiquidity or market illiquidity is computed for each month as the average of the illiquidity measure across all sample stocks.

Figure 1 plots market illiquidity during As can be seen, it is at the beginning of that illiquidity reaches its highest levels and starts to decline from that year onwards. This improvement in liquidity is because of the reorganisation and regulation of the Portuguese stock market, which led to its international recognition as a developed market in The end of the speculative bubble in the year also contributed to the deterioration of the liquidity levels.

These more recent financial crises are well reflected in increasing ZR. Portfolios formation procedure The limited number of listed stocks in Euronext Lisbon constrains the use of a large crosssection of portfolios with respect to a particular stock characteristic. Moreover, we take into account the suggestion of Lewellen et al.

  • Idiosyncratic Volatility and Liquidity Risk: How they have Explanatory Power in Stock Returns
  • Market liquidity

Thus, using portfolios constructed on the same basis as the risk factor may generate high cross-sectional R-squared values even though this factor is not able to explain the cross-section of true expected returns.

For those reasons, we include portfolios based on four different stock characteristics[4]: The availability of 20 characteristic portfolios provides an adequate number of test portfolios for the statistical power of crosssectional tests.

relationship between liquidity risk and stock price

The portfolio formation methodology consists of three steps. First, all sample stocks are ranked in ascending order of the stock characteristic. Third, the portfolio composition is revised every December and maintained throughout the following year. To be included in a portfolio, stocks must have been traded fromJanuary to December of year t.

relationship between liquidity risk and stock price

This means that for size portfolios, S1 represents the smallest year-end market capitalised firms and S5 represents the largest year-end market capitalised firms. With respect to beta risk, B1 is the portfolio that contains the 20 per cent of stocks with the lowest beta risk in December of each year and B5 is the portfolio containing the 20 per cent of stocks with the highest beta. The liquidity portfolios are ranked on annual information, based on the values of ZR computed with annual frequency.

The liquidity quintile portfolios increase in liquidity, so the stocks are sorted in descending order ZR. Therefore, L1 represents the most illiquid stocks and L5 contains the most liquid stocks in our sample. For each month and portfolio, we calculate the equally-weighted returns and illiquidity. We use the equal weighting scheme for the test portfolios, as this seems to be the usual methodology followed by liquidity-related studies. Summary statistics for test portfolios are presented in Table II.

This table shows that sorting based on previous year illiquidity allows for computing portfolios whose average liquidity ascends from L1 to L5. This means that illiquidity is persistent and less liquid assets in the previous year tend to be less liquid for a long time. This result justifies the estimation of liquidity innovations using autoregressive models, as explained in Section 5.

Moreover, there is no evidence of a relation between average portfolio returns and liquidity, which could suggest that it is not liquidity level but rather liquidity shocks that affect stock returns.

Almost all portfolios exhibit average negative returns in the period The only exception is the BM5 portfolio that has an average return of 0. This negative return can be explained by the high losses experienced in the stock market during the post-dot-com bubble and the financial crisis periods.

As expected, market value increases with liquidity because the most liquid stocks are also the stocks of firms with the largest capitalisation. Asset pricing with liquidity Previous empirical evidence suggests that there is commonality in illiquidity in Portugal Miralles-Marcelo et al. In this sense, as Chordia et al. Hence, in this section, we analyse the role of liquidity in asset pricing, within the context of CAPM and Acharya and Pedersen models.

This model states that the expected excess return of an asset is proportional to its covariance with market returns; thus, the only risk factor that matters is the market beta.

Nevertheless, it seems to have had limited empirical ability to explain asset returns in recent times, and some studies reveal that the CAPM model cannot explain the expected returns from some investment strategies based on firm characteristics such as liquidity. This model provides a unified framework for understanding the various channels through which liquidity risk may affect asset prices.

As in the standard CAPM, in the LCAPM model, the required return on an asset increases linearly with the market beta, that is covariance between the asset return and the market return. However, this model also yields three additional effects which could be regarded as three forms of liquidity risks.

The first effect is that the return increases with the covariance between the asset illiquidity and the market illiquidity. The second effect on expected returns is because of co-variation between a security return and the market illiquidity. And, finally, the third effect on required returns is because of covariation between security illiquidity and the market return.

We consider that the LCAPM model combines the two main arguments related to the consideration of illiquidity in asset pricing. The first argument is that illiquidity is a stock characteristic that acts as a market friction because individual illiquidity reduces stock returns.

The most useful indicators of liquidity for these contracts are the trading volume and open interest. There is also dark liquidityreferring to transactions that occur off-exchange and are therefore not visible to investors until after the transaction is complete.

It does not contribute to public price discovery. Managing liquidity is a daily process requiring bankers to monitor and project cash flows to ensure adequate liquidity is maintained. Maintaining a balance between short-term assets and short-term liabilities is critical. For an individual bank, clients' deposits are its primary liabilities in the sense that the bank is meant to give back all client deposits on demandwhereas reserves and loans are its primary assets in the sense that these loans are owed to the bank, not by the bank.

The investment portfolio represents a smaller portion of assets, and serves as the primary source of liquidity.

relationship between liquidity risk and stock price

Investment securities can be liquidated to satisfy deposit withdrawals and increased loan demand. Banks have several additional options for generating liquidity, such as selling loans, borrowing from other banksborrowing from a central banksuch as the US Federal Reserve bankand raising additional capital.

In a worst-case scenario, depositors may demand their funds when the bank is unable to generate adequate cash without incurring substantial financial losses.

There was a problem providing the content you requested

In severe cases, this may result in a bank run. Most banks are subject to legally mandated requirements intended to help avoid a liquidity crisis. A lack of liquidity can be remedied by raising deposit rates and effectively marketing deposit products. However, an important measure of a bank's value and success is the cost of liquidity. A bank can attract significant liquid funds. Lower costs generate stronger profits, more stability, and more confidence among depositors, investors, and regulators.

Stock market[ edit ] In the market, liquidity has a slightly different meaning, although still tied to how easily assets, in this case shares of stock, can be converted to cash. Generally, this translates to where the shares are traded and the level of interest that investors have in the company.

For illiquid stocks, the spread can be much larger, amounting to a few percent of the trading price.

relationship between liquidity risk and stock price

When stock prices rise, it is said to be due to a confluence of extraordinarily high levels of liquidity on household and business balance sheets, combined with a simultaneous normalization of liquidity preferences. On the margin, this drives a demand for equity investments. Literature[ edit ] Christoph G. An empirical analysis of the impact of the financial crisis, ownership structures and insider trading.

relationship between liquidity risk and stock price

Abudy, Menachem Meni; Raviv, Alon Journal of Financial Stability.