Liquidity and Stock Returns: New Evidence From Johannesburg Stock Exchange

Abstract

After the 2007/9 financial crisis, liquidity risk became the most dreaded financial risk of all times. However, our modern finance theories are modeled on the premises that markets are frictionless and hence liquidity plays no role, yet there is a plethora of literature that attest to the fact that liquidity is a cost that needs to be priced. This confirms the fact that markets are indeed full of friction and therefore, liquidity needs to be modeled accordingly. In this paper, a time-series regression approach is adopted to investigate the relationship between stock illiquidity and stock excess return on the JSE. The basis of the methodology followed in this study is that of Fama and MacBeth's (1973) cross-sectional multiple regression analysis. Specifically, Fama and French three-factor model plus liquidity is employed to test empirically the relationship between stock excess returns and liquidity together with other known, important time-series determinants of stock returns, such as beta, size, and book-to-market ratio. Liquidity is then added to the three factor model as the fourth factor thus, in addition to the excess return on the market. The results from this study show that liquidity is an important factor in pricing returns on the JSE as the stock excess returns are positively related to illiquidity and the relationship is significant. More specifically, the study revealed that the expected excess returns are positively and significantly related to stock systematic risk as measured by beta. This was the case across all the portfolios that were investigated. The three factor model shows a negative relationship though not significant. The there-factor model plus liquidity showed a positive relationship but not significant. Given the exhibited importance of liquidity in determining stock return, stock liquidity should be incorporated in dynamic stochastic general equilibrium models since markets in reality are not frictionless. Given that highly illiquid stocks are associated with higher expected returns as compared to liquid stocks, the conversional finance theories should be revised to reflect this new insight as this is a confirmation that markets have friction, thus liquidity plays an important role in the modeling of required return.