Maximum Bid-Ask Spreads and Expected Stock Returns

Abstract

The return premium associated with the illiquidity of stocks is well documented. In this study, we focus our attention on the uncertainty of liquidity. We test whether brief but significant liquidity droughts, as measured by the maximum daily bid-ask spread during a particular month, are associated with the illiquidity premium. Results show a robust return premium associated with stocks with the largest maximum bid-ask spread. We find that stocks with the largest maximum spreads generate alphas of approximately 1% per month. These results are distinct from premiums associated with the bid-ask spread and hold in a multi-factor setting after controlling for the Pastor-Stambaugh liquidity risk factor.