Abstract
In this research article, we present a liquidity premium based asset pricing model and test it in the Indian stock market. Using high-frequency data of stocks listed in the National Stock Exchange, we show that observed illiquidity has a significant negative impact on realized stock returns even after controlling for the up and down market, volatility, and effects of derivatives trading. The illiquidity measure is modified for its time variations, and then the modified measure is used to assess its impact on returns. Using a cross-section of stocks, we show the year wise results of the model and extend it to show that it has some role in explaining returns across industries. Findings show that the down market has contemporaneous systematic risk at higher levels, and the market risk premium is higher in down markets. Finance, utility and real estate sector companies have higher systematic risk in both up and down market and investors of these sectors has relatively higher expected higher returns in comparison to companies from the rest of the segments.
Highlights
We show that an increase in volatility does not necessarily lead to an increase or decrease in coefficient of market risk premium but an increase in open interest in the market increases in the coefficient of market risk premium
Extending the standard Capital Asset Pricing Model (CAPM) to include security-specific and market-level liquidity premiums (Acharya & Pedersen, 2005) explain how liquidity variations result in low realized returns and high expected returns using the data of NYSE and AMEX
Stereńczak et al (2020) investigated the influence of the absence of liquidity across frontier markets which are expected to be less integrated with other markets. They used a battery of liquidity proxies and covered both pre and post-global financial crisis period to conclude that there is no liquidity premium for investors investing in those stock markets
Summary
Liquidity is an underlying concept without a universal definition. The most accepted notion of liquidity is the capability of an asset to trade in a market with minimal price disruption. Garleanu & Pedersen (2007) and Brunnermeier & Pedersen (2009) supported the idea that there is an asymmetric influence of illiquidity on different states of the market They supported this on the grounds of liquidity tremors, margin-induced price spirals, and tighter risk management by institutions. A market participant is more worried about the informational role of illiquidity during periods of negative returns for asset pricing than the periods of positive returns. Chordia et al (2001b) studied the time variations in liquidity, and they foresighted the role of unexpected liquidity in asset pricing models They stressed the importance of understanding of nature of the relationship between liquidity and stock returns to improve the level of market participant's confidence in the stock market. We modify the illiquidity measure of (Amihud, 2002) for time-varying effects and show that unexpected illiquidity negatively impacts stock return in the Indian market.
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