Does liquidity drive stock market returns? The role of investor risk aversion

Qingjing Zhang,Xiaoquan Liu,Jing-Ming Kuo,Taufiq Choudhry

doi:10.1007/s11156-021-00966-5

Abstract

In this paper, we explore the relations between liquidity, stock returns, and investor risk aversion as captured by the variance risk premium (VRP). This is motivated by theoretical and empirical evidence in the literature which suggests that investor risk aversion negatively correlates with asset liquidity, and ample empirical evidence documenting liquidity risk premium. We use monthly US data from January 1999 to December 2018 and show that innovations in the VRP Granger-cause stock returns, which in turn drive liquidity. Our findings are consistent with predictions of prior theories and highlight the predictability of the VRP. They also contribute to the on-going debate on the causal relation between stock returns and liquidity. Finally, we explore the channels through which the VRP impacts liquidity and find that the VRP influences market and momentum factors, and that movements in these factors lead to changes in liquidity.

Highlights

The relation between risk and expected asset returns is at the centre of financial economics literature (Merton 1973)
In this paper, we explore the relations between liquidity, stock returns, and investor risk aversion as captured by the variance risk premium (VRP)
In the literature, the VRP – considered an indicator capturing investor risk aversion and aggregate economic uncertainty – and liquidity are both useful variables for explaining innovations in stock returns

Summary

Introduction

The relation between risk and expected asset returns is at the centre of financial economics literature (Merton 1973). The results from the Toda-Yamamoto Granger non-causality test with tri- and bi-variate VAR models provide strong evidence to suggest that investor risk aversion Granger-causes stock market returns, and in turn, affects illiquidity. It is worth noting that the negative impact is significant for more than ten months following the shock, consistent with the findings from the Toda-Yamamoto Granger non-causality test indicating that changes in stock market returns lead to innovations in illiquidity. We conduct the Toda-Yamamoto Granger non-causality tests with the application of tri-variate vector autoregression (VAR) models for the relationship between the VRP, stock market returns, and liquidity with conventional economic controls using Liu (2006) liquidity measure. The results show that illiquidity does not Granger-cause any of the factors, and does not affect stock returns

Conclusion

PE DFSP TMSP RREL CAY

Response of VRPDY to ILIQSP

Findings

In Sample