Abstract
This paper finds a significant positive relation between illiquidity and conditional variance of stock returns, both at the individual and aggregate levels. For each of the largest two hundred stocks on the NYSE and NASDAQ, we estimate a GARCH model in which share turnover and proportional spread enter the conditional variance equitation. We find that, for 75% of the stocks examined, proportional spread is a significant and positive determinant of conditional heteroscedasticity after orthogonalization against share turnover and return. Alternative measures of illiquidity also have a strong positive effect on the variability of aggregate market return. In support of these findings, we present a simple market microstructural model in which conditional return variance is a positive and nonlinear function of stochastic Kyle's lambda.
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