China's illiquidity premium: Due to risk-taking or mispricing?

Abstract

This study focuses on China's A-share market and investigates the existence and underlying source of the illiquidity premium. We observe a significant and positive relationship between stock illiquidity and expected returns. Moreover, relative to illiquid stocks, liquid stocks are more susceptible to overpricing during high sentiment periods and earn lower abnormal returns following high sentiment periods, thus supporting the sentiment-driven mispricing explanation. We also find evidence that the illiquidity premium fails to reflect exposure to underlying risk. Overall, China's illiquidity premium derives from mispricing instead of risk-taking.