Liquidity Risk and Expected Stock Returns

Liquidity Risk and Expected Stock Returns

Author Name: Paster and Stambaugh

Executive Summary

There is significant commonality in various liquidity measures at a daily frequency found by Chordia, Roll, and Subrabmanyam (2000) and Huberman and Halka (2001). However, Hasbrouck and Seppi (2001) pointed out that there is little commonality in liquidity fluctuations in daily frequency. The main purpose of this paper is to do the research whether liquidity is a reason of priced risk in stock returns, which means market wide liquidity is important for asset pricing. Moreover, the authors attempted to find out the evidence that fluctuations in liquidity reflect commonality through stocks.

In general, this article can be divided into five parts, there are aggregate states about market wide liquidity, and the relation between stock’s expected return and liquidity and an investment perspective, apart from introduction and conclusion. Among these parts, the authors showed a lot of analysis based on the financial models. For example, in the second section the authors explained the liquidity measures and gave the detailed data analysis with previous research. The authors firstly built a model to investigate the relation between temporary price changes and the order flow and explain the characteristics of the liquidity measure and then focused on liquidity and asset pricing. The third section also included several additional things, which were sorting by predicted liquidity betas, sorting by historical liquidity betas, sorting by size and individual stock liquidity. Finally, the authors used an investment perspective to show that momentum is affected by spreads significantly.

As can be seen clearly from this paper, the authors used a large amount of data and figures and tables to explain their opinions and give the evidence. The liquidity risk in returns’ relation to expected stock returns was tested by numerous empirical studies, including Amihud and Mendelson (1986),...