Abstract
We investigate what determines a stock’s uncertainty elasticity of liquidity (UEL: the change in the individual stock’s liquidity given the change in the market return volatility) and whether UEL is priced for China’s A-shares. We find stocks with higher UEL are associated with lower share price, smaller market capitalization, higher illiquidity ratio, lower institutional ownership, and fewer shareholders. Furthermore, those stocks have higher market risk and liquidity risk according to Acharya and Pedersen (2005)’s liquidity capital asset pricing model. From May 2004 to April 2017, our results show that the highest UEL equally-weighted decile portfolio significantly outperforms the lowest UEL equally-weighted decile portfolio by 1.19% per month and the risk adjusted UEL premium by the 6-factor (Fama and French (2015) five factor plus a momentum factor) model remains significant at 0.28% per month. Moreover, we find the UEL premium matters more for illiquid stocks with less investor attention. Finally, we find UEL fails to subsume the explanatory power of liquidity risk on cross-sectional stock returns and liquidity commonality is the most important dimension of liquidity risk for China’s A-shares.
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