Illiquidity premium and expected stock returns in the UK: A new approach

TY - JOUR

T1 - Illiquidity premium and expected stock returns in the UK: A new approach

AU - Chen,Jiaqi

AU - Sherif,Mohamed

PY - 2016/9/15

Y1 - 2016/9/15

N2 - This study examines the relative importance of liquidity risk for the time-series and cross-section of stock returns in the UK. We propose a simple way to capture the multidimensionality of illiquidity. Our analysis indicates that existing illiquidity measures have considerable asset specific components, which justifies our new approach. Further, we use an alternative test of the Amihud (2002) measure and parametric and non-parametric methods to investigate whether liquidity risk is priced in the UK. We find that the inclusion of the illiquidity factor in the capital asset pricing model plays a significant role in explaining the cross-sectional variation in stock returns, in particular with the Fama–French three-factor model. Further, using Hansen–Jagannathan non-parametric bounds, we find that the illiquidity-augmented capital asset pricing models yield a small distance error, other non-liquidity based models fail to yield economically plausible distance values. Our findings have important implications for managing the liquidity risk of equity portfolios.

AB - This study examines the relative importance of liquidity risk for the time-series and cross-section of stock returns in the UK. We propose a simple way to capture the multidimensionality of illiquidity. Our analysis indicates that existing illiquidity measures have considerable asset specific components, which justifies our new approach. Further, we use an alternative test of the Amihud (2002) measure and parametric and non-parametric methods to investigate whether liquidity risk is priced in the UK. We find that the inclusion of the illiquidity factor in the capital asset pricing model plays a significant role in explaining the cross-sectional variation in stock returns, in particular with the Fama–French three-factor model. Further, using Hansen–Jagannathan non-parametric bounds, we find that the illiquidity-augmented capital asset pricing models yield a small distance error, other non-liquidity based models fail to yield economically plausible distance values. Our findings have important implications for managing the liquidity risk of equity portfolios.

U2 - 10.1016/j.physa.2016.03.035

DO - 10.1016/j.physa.2016.03.035

M3 - Article

VL - 458

SP - 52

EP - 66

JO - Physica A: Statistical Mechanics and its Applications

T2 - Physica A: Statistical Mechanics and its Applications

JF - Physica A: Statistical Mechanics and its Applications

SN - 0378-4371

ER -