In classical asset pricing models, perfect financial markets without frictions, especially no trading costs, are assumed and thus the diverse features of liquidity are ignored. However, considering liquidity in investment is important since liquidity affects portfolio investment performance (Holthausen, Leftwich, and Mayers (1991), Keim (2003), Lesmond, Schill, and Zhou (2004), Korajczyk and Sadka (2005)) and since it has a significant implication for portfolio diversification strategies (Domowitz and Wang (2002), Harford and Kaul (2004)). In addition, it has been shown that liquidity affects the cross-sectional differences of asset returns as a characteristic (Amihud and Mendelson (1986), Brennan and Subrahmanyam (1996), Amihud (2002)) or as a risk factor (Pastor and Stambaugh (2003), Sadka (2004), Acharya and Pederson (2005)).
The amount of research on the implication of liquidity on asset pricing at a global level is small relative to that for the US market. Rouwenhorst (1999) investigates the cross-sectional relation between asset returns and liquidity in 20 countries from emerging markets and found that small stocks or value stocks have higher average turnover than large or growth stocks, a finding he acknowledges to be hard to justify by existing liquidity theories. For 19 emerging markets, Bekaert, Harvey, and Lundblad (2003) show that the covariance of country-portfolio returns with local market liquidity predicts future returns, but they could not find evidence that global liquidity risk is priced. On the contrary, Stahel (2004b) investigates the existence of market-wide comovements of liquidity of individual stocks at the country, industry and global market level in 3 developed countries of Japan, UK and US.
While these papers are pioneering efforts, they share common limitations. First, the only liquidity risk considered in the previous literature is the one that arises from the sensitivity of individual stock returns with market-wide liquidity which is shown in Pastor and Stambaugh (2003) to be priced for the US market. However, none of these studies deal with the pricing of liquidity risks arising from the covariance of individual stock liquidity with market-wide liquidity (commonality in liquidity) and that arising from the covariance of individual stock liquidity with market returns. Second, all of these studies have focused on either emerging markets or developed markets separately, and thus their global market liquidity intrinsically reflects only part of the world. Third, except for Rouwenhorst (1999), all these studies employ a portfolio-level analysis rather than the analysis at individual stock level to investigate the asset pricing implication of liquidity.
This paper investigates an equilibrium asset pricing relationship with liquidity both as a characteristic and as a risk factor in international financial markets using over 28,000 stocks from 48 countries for January 1988 to December 2004. To our knowledge, this is the first paper that encompasses stocks from both emerging and developed markets in an individual stock-level analysis of world market liquidity dealing with multiple forms of liquidity risks as well as market risk similar to Acharya and Pederson (2005)’s liquidity adjusted asset pricing model (LCAPM) but for international financial markets.
We employ a variety of test methods. In our Fama-MacBeth cross-sectional tests, we compute both post-ranking and predicted betas and time-series method, we test the unconditional version of LCAPM extended to the international financial markets. Each extension is based on a different degree of integration of world financial markets. We find that a security’s required return depends on its expected illiquidity and on the covariances of its own return and illiquidity with global market returns. Specifically, the global liquidity risk arising from the covariance of individual stock liquidity with global market returns is priced and a trading strategy based on such non-traded global liquidity risk is shown to produce annual 6% abnormal returns.
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The World Price of Liquidity Risk
