Market Volatility, Liquidity, and Stock Returns

Abstract

This study shows that market uncertainty affects stock returns both directly and indirectly through its impact on liquidity. In particular, we show that a stock’s return is more sensitive to unexpected changes in market uncertainty when its liquidity disappears more visibly in response to uncertainty shocks, indicating that liquidity is an important channel through which market uncertainty affects stock returns. We also find evidence that investors underreact to unexpected changes in market uncertainty and stock liquidity. Consistent with our expectation, stock returns are more sensitive to uncertainty shocks in the high-frequency trading era, and after the regulatory changes in the US markets that increased competition between public traders and market makers, reduced the tick size, and decreased or eliminated the role of NASDAQ dealers and NYSE specialists in the price discovery process. JEL classification: G01, G02, G10, G18