Expected Returns and Markov-Switching Illiquidity

Abstract

Recent theoretical models imply that liquidity is fragile: financial markets are liquid in some equilibria and illiquid in others. This paper employs an intuitively appealing Markov-switching regime model to investigate the episodic nature of stock market illiquidity and the intertemporal relation between illiquidity risk and expected stock returns. We introduce a two-state Markov-switching regime model for stock market illiquidity, returns and volatility. We find evidence of a significant illiquidity risk premium; the expected stock return is positively related to the conditional probability of an illiquid regime. By combining the Markov-switching model with a log-linear model for stock returns, we derive a tractable expression for the illiquidity feedback effect. Modeling the illiquidity feedback effect is critical to understanding the relation between realized stock returns, expected returns and Markov-switching illiquidity. We develop a flexible Bayesian Markov chain Monte Carlo (MCMC) approach for estimating and comparing models.