Hostname: page-component-78c5997874-v9fdk Total loading time: 0 Render date: 2024-11-15T06:34:11.643Z Has data issue: false hasContentIssue false
  • English
  • Français

Stock Returns and the Volatility of Liquidity

Published online by Cambridge University Press:  08 June 2010

João Pedro Pereira  and
Harold H. Zhang
João Pedro Pereira
Affiliation:
ISCTE Business School–Lisbon, Finance Department, Av. Forcas Armadas, 1649-026 Lisboa, Portugal. joao.pereira@iscte.pt
Harold H. Zhang
Affiliation:
University of Texas at Dallas, School of Management, PO Box 830688, Richardson, TX 75080. harold.zhang@utdallas.edu
Get access Rights & Permissions [Opens in a new window]

Abstract

This paper offers a rational explanation for the puzzling empirical fact that stock returns decrease with an increase in the volatility of liquidity. We model liquidity as a stochastic price impact process and define the liquidity premium as the additional return necessary to compensate a multiperiod investor for the adverse price impact of trading. The model demonstrates that a fully rational, utility maximizing, risk-averse investor can take advantage of time-varying liquidity by adapting his trades to the state of liquidity. We provide new empirical evidence supportive of the model.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 45 , Issue 4 , August 2010 , pp. 1077 - 1110
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2010

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Acharya, V. V., and Pedersen, L. H.. “Asset Pricing with Liquidity Risk.” Journal of Financial Economics, 77 (2005), 375–410.CrossRefGoogle Scholar
Admati, A. R., and Pfleiderer, P.. “A Theory of Intraday Patterns: Volume and Price Variability.” Review of Financial Studies, 1 (1988), 3–40.CrossRefGoogle Scholar
Almgren, R., and Chriss, N.. “Optimal Execution of Portfolio Transactions.” Journal of Risk, 3 (2000), 5–39.CrossRefGoogle Scholar
Amihud, Y. “Illiquidity and Stock Returns: Cross-Section and Time-Series Effects.” Journal of Financial Markets, 5 (2002), 31–56.CrossRefGoogle Scholar
Amihud, Y., and Mendelson, H.. “Asset Pricing and the Bid-Ask Spread.” Journal of Financial Economics, 17 (1986), 223–249.CrossRefGoogle Scholar
Amihud, Y.; Mendelson, H.; and Pedersen, L. H.. “Liquidity and Asset Prices.” Foundations and Trends in Finance, 1 (2005), 269–364.CrossRefGoogle Scholar
Bertsekas, D. P. Dynamic Programming and Optimal Control, Vol. 1, 2nd ed.Belmont, MA: Athena Scientific (2000).Google Scholar
Bertsimas, D., and Lo, A. W.. “Optimal Control of Execution Costs.” Journal of Financial Markets, 1 (1998), 1–50.CrossRefGoogle Scholar
Breen, W. J.; Hodrick, L. S.; and Korajczyk, R. A.. “Predicting Equity Liquidity.” Management Science, 48 (2002), 470–483.CrossRefGoogle Scholar
Brennan, M. J.; Chordia, T.; and Subrahmanyam, A.. “Alternative Factor Specifications, Security Characteristics, and the Cross-Section of Expected Stock Returns.” Journal of Financial Economics, 49 (1998), 345–373.CrossRefGoogle Scholar
Brennan, M. J., and Subrahmanyam, A.. “Market Microstructure and Asset Pricing: On the Compensation for Illiquidity in Stock Returns.” Journal of Financial Economics, 41 (1996), 441–464.CrossRefGoogle Scholar
Brunnermeier, M. K., and Pedersen, L. H.. “Predatory Trading.” Journal of Finance, 60 (2005), 1825–1863.CrossRefGoogle Scholar
Carlin, B. I.; Lobo, M. S.; and Viswanathan, S.. “Episodic Liquidity Crises: Cooperative and Predatory Trading.” Journal of Finance, 62 (2007), 2235–2274.CrossRefGoogle Scholar
Cetin, U.; Jarrow, R.; Protter, P.; and Warachka, M.. “Pricing Options in an Extended Black Scholes Economy with Illiquidity: Theory and Empirical Evidence.” Review of Financial Studies, 19 (2006), 493–529.CrossRefGoogle Scholar
Chan, L. K. C., and Lakonishok, J.. “The Behavior of Stock Prices around Institutional Trades.” Journal of Finance, 50 (1995), 1147–1174.CrossRefGoogle Scholar
Chiyachantana, C. N.; Jain, P. K.; Jiang, C.; and Wood, R. A.. “International Evidence on Institutional Trading Behavior and Price Impact.” Journal of Finance, 59 (2004), 869–898.CrossRefGoogle Scholar
Chordia, T.; Roll, R.; and Subrahmanyam, A.. “Market Liquidity and Trading Activity.” Journal of Finance, 56 (2001), 501–530.CrossRefGoogle Scholar
Chordia, T.; Sarkar, A.; and Subrahmanyam, A.. “An Empirical Analysis of Stock and Bond Market Liquidity.” Review of Financial Studies, 18 (2005a), 85–129.CrossRefGoogle Scholar
Chordia, T.; Sarkar, A.; and Subrahmanyam, A.. “Liquidity Dynamics and Cross-Autocorrelations.” Working Paper, SSRN eLibrary (2005b).Google Scholar
Chordia, T.; Subrahmanyam, A.; and Anshuman, V. R.. “Trading Activity and Expected Stock Returns.” Journal of Financial Economics, 59 (2001), 3–32.CrossRefGoogle Scholar
Christoffersen, S. K.; Keim, D. B.; and Musto, D. K.. “Valuable Information and Costly Liquidity: Evidence from Individual Mutual Fund Trades.” Working Paper, SSRN eLibrary (2007).CrossRefGoogle Scholar
Constantinides, G. M. “Capital Market Equilibrium with Transaction Costs.” Journal of Political Economy, 94 (1986), 842–862.CrossRefGoogle Scholar
Constantinides, G. M., and Scholes, M. S.. “Optimal Liquidation of Assets in the Presence of Personal Taxes: Implications for Asset Pricing.” Journal of Finance, 35 (1980), 439–449.CrossRefGoogle Scholar
Datar, V. T.; Naik, N. Y.; and Radcliffe, R.. “Liquidity and Stock Returns: An Alternative Test.” Journal of Financial Markets, 1 (1998), 203–219.CrossRefGoogle Scholar
Dufour, A., and Engle, R. F.. “Time and the Price Impact of a Trade.” Journal of Finance, 55 (2000), 2467–2498.CrossRefGoogle Scholar
Economides, N., and Schwartz, R.. “Equity Trading Practices and Market Structure: Assessing Asset Managers’ Demand for Immediacy.” Financial Markets, Institutions and Instruments, 4 (1995), 1–46.Google Scholar
Falkenstein, E. G. “Preferences for Stock Characteristics as Revealed by Mutual Fund Portfolio Holdings.” Journal of Finance, 51 (1996), 111–135.CrossRefGoogle Scholar
Fama, E. F., and French, K. R.. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics, 33 (1993), 3–56.CrossRefGoogle Scholar
Fama, E. F., and MacBeth, J. D.. “Risk, Return, and Equilibrium: Empirical Tests.” Journal of Political Economy, 81 (1973), 607–636.CrossRefGoogle Scholar
Foster, F. D.; Gallagher, D. R.; and Looi, A.. “Institutional Trading and Share Returns.” Working Paper, SSRN eLibrary (2005).CrossRefGoogle Scholar
Foster, F. D., and Viswanathan, S.. “A Theory of the Interday Variations in Volume, Variance, and Trading Costs in Securities Markets.” Review of Financial Studies, 3 (1990), 593–624.CrossRefGoogle Scholar
Gallant, A. R.; Rossi, P. E.; and Tauchen, G.. “Stock Prices and Volume.” Review of Financial Studies, 5 (1992), 199–242.CrossRefGoogle Scholar
Ghysels, E., and Pereira, J. P.. “Liquidity and Conditional Portfolio Choice: A Nonparametric Investigation.” Journal of Empirical Finance, 15 (2008), 679–699.CrossRefGoogle Scholar
Glosten, L. R., and Harris, L. E.. “Estimating the Components of the Bid/Ask Spread.” Journal of Financial Economics, 21 (1988), 123–142.CrossRefGoogle Scholar
Hasbrouck, J. “Measuring the Information Content of Stock Trades.” Journal of Finance, 46 (1991), 179–207.CrossRefGoogle Scholar
Hasbrouck, J. “Trading Costs and Returns for U.S. Equities: Estimating Effective Costs from Daily Data.” Working Paper, New York University (2006).Google Scholar
Hasbrouck, J. “Trading Costs and Returns for U.S. Equities: Estimating Effective Costs from Daily Data.” Journal of Finance, 64 (2009), 1445–1477.CrossRefGoogle Scholar
He, H., and Mamaysky, H.. “Dynamic Trading Policies with Price Impact.” Journal of Economic Dynamics and Control, 29 (2005), 891–930.CrossRefGoogle Scholar
Heaton, J., and Lucas, D. J.. “Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing.” Journal of Political Economy, 104 (1996), 443–487.CrossRefGoogle Scholar
Hiemstra, C., and Jones, J. D.. “Testing for Linear and Nonlinear Granger Causality in the Stock Price-Volume Relation.” Journal of Finance, 49 (1994), 1639–1664.Google Scholar
Holthausen, R. W.; Leftwich, R. W.; and Mayers, D.. “Large-Block Transactions, the Speed of Response, and Temporary and Permanent Stock-Price Effects.” Journal of Financial Economics, 26 (1990), 71–95.CrossRefGoogle Scholar
Huang, M. “Liquidity Shocks and Equilibrium Liquidity Premia.” Journal of Economic Theory, 109 (2003), 104–129.CrossRefGoogle Scholar
Huberman, G., and Stanzl, W.. “Optimal Liquidity Trading.” Review of Finance, 9 (2005), 165–200.CrossRefGoogle Scholar
Jang, B.-G.; Koo, H. K.; Liu, H.; and Loewenstein, M.. “Liquidity Premia and Transaction Costs.” Journal of Finance, 62 (2007), 2329–2366.CrossRefGoogle Scholar
Keim, D. B., and Madhavan, A.. “The Upstairs Market for Large-Block Transactions: Analysis and Measurement of Price Effects.” Review of Financial Studies, 9 (1996), 1–36.CrossRefGoogle Scholar
Keim, D. B., and Madhavan, A.. “Transactions Costs and Investment Style: An Inter-Exchange Analysis of Institutional Equity Trades.” Journal of Financial Economics, 46 (1997), 265–292.CrossRefGoogle Scholar
Korajczyk, R. A., and Sadka, R.. “Pricing the Commonality across Alternative Measures of Liquidity.” Journal of Financial Economics, 87 (2008), 45–72.CrossRefGoogle Scholar
Koren, M., and Szeidl, A.. “Portfolio Choice with Illiquid Assets.” Working Paper, Harvard University (2002).Google Scholar
Kyle, A. S. “Continuous Auctions and Insider Trading.” Econometrica, 53 (1985), 1315–1335.CrossRefGoogle Scholar
Lipson, M. L., and Puckett, A.. “Institutional Trading during Extreme Market Movements.” Working Paper, University of Virginia (2007).Google Scholar
Lo, A. W.; Mamaysky, H.; and Wang, J.. “Asset Prices and Trading Volume under Fixed Transactions Costs.” Journal of Political Economy, 112 (2004), 1054–1090.CrossRefGoogle Scholar
Lo, A. W., and Wang, J.. “Trading Volume: Definitions, Data Analysis, and Implications of Portfolio Theory.” Review of Financial Studies, 13 (2000), 257–300.CrossRefGoogle Scholar
Longstaff, F. A. “Optimal Portfolio Choice and the Valuation of Illiquid Securities.” Review of Financial Studies, 14 (2001), 407–431.CrossRefGoogle Scholar
Merton, R. C. “Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case.” Review of Economics and Statistics, 51 (1969), 247–257.CrossRefGoogle Scholar
Obizhaeva, A., and Wang, J.. “Optimal Trading Strategy and Supply/Demand Dynamics.” Working Paper, MIT (2006).CrossRefGoogle Scholar
Pástor, Ľ., and Stambaugh, R. F.. “Liquidity Risk and Expected Stock Returns.” Journal of Political Economy, 111 (2003), 642–685.CrossRefGoogle Scholar
Saar, G. “Price Impact Asymmetry of Block Trades: An Institutional Trading Explanation.” Review of Financial Studies, 14 (2001), 1153–1181.CrossRefGoogle Scholar
Sadka, R. “Momentum and Post-Earnings-Announcement Drift Anomalies: The Role of Liquidity Risk.” Journal of Financial Economics, 80 (2006), 309–349.CrossRefGoogle Scholar
Seppi, D. J. “Block Trading and Information Revelation around Quarterly Earnings Announcements.” Review of Financial Studies, 5 (1992), 281–305.CrossRefGoogle Scholar
Sias, R. W.; Starks, L. T.; and Titman, S.. “The Price Impact of Institutional Trading.” Working Paper, Washington State University (2001).CrossRefGoogle Scholar
Vayanos, D. “Transaction Costs and Asset Prices: A Dynamic Equilibrium Model.” Review of Financial Studies, 11 (1998), 1–58.CrossRefGoogle Scholar