Ebook Systematic Liquidity, Characteristic Liquidity And Asset Pricing
Numerous studies, starting from Amihud and Mendelson (1986) have shown that liquidity is an important variable that affects the stock prices. Using various measures of liquidity, these studies generally support the liquidity premium theory, which provides a rationale for a trade off between return on assets and their liquidity. In general, higher rate of returns are associated with less liquid assets.. For example, using bid-ask spread as a measure of liquidity, Amihud and Mendelson (1986) show that the quoted bid-ask spread has a significant positive effect on stock returns. Similarly, Eleswarapu and Reinganum (1993) using the same quoted bid-ask spread as a proxy for liquidity find that the positive relation documented in Amihud and Mendelson is restricted only in January.
Brennan and Subrahmanyam (1996) take an innovative approach by estimating the price impact of a trade based on Kyle’s (1985) model and find that it is significantly positively related to average returns. Easley, Hvidkjaer, and O’Hara (2002) document a similar result using their measure of illiquidity called the probability of information trading, which reflects the adverse selection cost arising from information asymmetry among traders. Additional evidence on positive illiquidity-return relation is provided by Chalmers and Kadlec (1998) using the amortized bid-ask spread, by Datar, Naik, and Radcliff (1998) using share turnover, by Brennan, Chordia, and Subrahmanyam (1998) using dollar trading volume, and most recently by Hasbrouck (2003) using a liquidity proxy based on a newly created effective spread in the daily data.
While the above cited studies support the liquidity premium notion, it is important to note that in these papers, liquidity is considered as a stock characteristic rather than an aggregate risk factor of concern to investors. The recent discovery of commonality in liquidity by Chordia, Roll, and Subrahmanyam (2000), Hasbrouck and Seppi (2001), and Huberman and Halka (2001) has raised a new question about the role of liquidity in asset pricing. Their findings spurred further research that investigates whether market-wide liquidity is an important factor in explaining stock returns.
A notable work by Pastor and Stambaugh (2003) develops a measure of aggregate liquidity, based on daily price reversal, and shows that stocks whose returns are more sensitive to market liquidity factor command higher required rate of return than stocks whose returns are less sensitive to market liquidity factor. Jacoby, Fowler, and Gottesman (2000) (JFG) develop a static one-period CAPM-based model to demonstrate that the true measure of systematic risk, when considering liquidity costs, is based on net (after bid-ask spread) returns.
A dynamic version of the JFG liquidity-adjusted CAPM is presented by Acharya and Pedersen (2005) (assuming overlapping-generations), where the JFG liquidity adjusted beta is decomposed into four components: the standard CAPM beta, and the three betas related to liquidity, one of which is the Pastor and Stambaugh (2003) liquidity beta and the other two are commonality in liquidity with market liquidity and liquidity sensitivity to market return. Using the liquidity measure of Amihud (2002), Acharya and Pedersen test the liquidity adjusted CAPM and show that their model significantly improves the performance of a standard CAPM for most portfolios. Chan and Faff (2005) examine the role of liquidity in asset pricing for the Australian stock market and suggest augmenting the Fama-French (1993) three-factor model to a four-factor model by incorporating the liquidity as the forth factor.
The findings that have emerged from the recent literature on liquidity and asset pricing discussed above obviously lead to a pertinent question from an asset-pricing perspective. Does liquidity beta (i.e., sensitivity of stock return to market liquidity) capture the effect of characteristic liquidity specific to individual stocks? Alternatively, if investors demand a risk premium for systematic liquidity, do they still demand another risk premium for the liquidity level per se? This question has not been answered conclusively in the literature thus far. Pastor and Stambaugh (2003) suggest that stocks with higher liquidity betas tend to have higher average return about 7.5 percent annual.
However, they do not control for the level of illiquidity, which has been shown to command a significant premium in a number of studies (see the above citations). Acharya and Pedersen (2005) within the framework of the liquidity-adjusted CAPM, show that the expected return of a security is increasing in its expected illiquidity and its liquidity risk. They show that illiquid securities also have high liquidity risk. However, their evidence that the total effect of the liquidity risk matters over and above market risk and the level of liquidity . is rather weak. Acharya and Pedersen do not control for the effect of Fama-French factors and their analyses are limited to NYSE and AMEX stocks only.
Nguyen, Mishra, Prakash and Ghosh (2006) using turnover ratio as a measure of liquidity find that a liquidity premium exists in stock market even after adjusting for market factors, non market factors as well as other stock characteristics. However, since their focus is whether the three-moment CAPM and the four-factor model which includes Fama-French and Pastor Stambaugh factors can explain liquidity premium, it is not clear whether the market liquidity factor alone can explain the impact of liquidity level per se.
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