The pricing of systematic liquidity risk in stock markets

José Luis Miralles Marcelo,José Luis Miralles Quirós,Maria Del Mar Miralles Quirós

doi:10.14195/2183-203x_20_8

José Luis Miralles Marcelo, José Luis Miralles Quirós + Show 1 more

Open Access

https://doi.org/10.14195/2183-203x_20_8

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Journal: Notas Económicas	Publication Date: Sep 23, 2016
Citations: 1	License type: CC BY 4.0

Affiliation: University of Coimbra

Abstract

The question whether liquidity affects asset returns or not remains unresolved thus far. The absence of conclusive results in previous research suggests that asset pricing and liquidity have not been properly addressed in the standard literature. We consider that systematic liquidity shocks affect the optimal behavior of agents in financial markets. Indeed, fluctuations in various measures of liquidity are significantly correlated across common stocks. Accordingly, we propose the construction of a liquidity risk factor based on the ratio of absolute stock returns on euro volume suggested by Amihud (2002) and the approximately orthogonalizing procedure of Fama and French (1993), using it as an augmenting variable in their three-factor model.

Highlights

It is generally accepted that asset liquidity influences investors’ portfolio decisions because of its close relation to transaction costs
We have analyzed the role of liquidity as an additional factor in asset pricing
The motivation for our study was provided by the growing interest in liquidity that has emerged in the asset pricing literature over recent years

Summary

Introduction

It is generally accepted that asset liquidity influences investors’ portfolio decisions because of its close relation to transaction costs. It is reasonable to think that investors who buy illiquid assets require higher expected returns on their investments because a lack of liquidity can be interpreted as an additional risk. The question of whether or not liquidity affects asset returns remains unresolved. While various theoretical models have indicated that liquidity risk is an important factor in explaining returns, empirical studies have failed to find significance for this liquidity risk factor. The reason could be that liquidity-risk measures are weak or proxy total instead of systematic liquidity risk. This paper contributes to the determination of the role of a liquidity factor in the structure of returns. Our main objective is to re-assess the role of liquidity risk, in the context of a Fama and French (1993) framework, by using the measure of systematic liquidity risk proposed by Amihud (2002)

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Conclusion