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Given the cross-sectional and temporal variation in their liquidity, emerging equity markets provide an ideal setting to examine the impact of liquidity on expected returns. Our main liquidity measure is a transformation of the proportion of zero daily firm returns, averaged over the month. We find that our liquidity measures significantly predict future returns, whereas alternative measures such as turnover do not. Consistent with liquidity being a priced factor, unexpected liquidity shocks are positively correlated with contemporaneous return shocks and negatively correlated with shocks to the dividend yield. We consider a simple asset pricing model with liquidity and the market portfolio as risk factors and transaction costs that are proportional to liquidity. The model differentiates between integrated and segmented countries and periods. Our results suggest that local market liquidity is an important driver of expected returns in emerging markets, and that the liberalization process has not eliminated its impact.

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We examine the effects of both equity market liberalization and capital account openness on real consumption growth variability. We show that financial liberalization is mostly associated with lower consumption growth volatility. Our results are robust, surviving controls for business-cycle effects, economic and financial development, the quality of institutions, and other variables. Countries that have more open capital accounts experience a greater reduction in consumption growth volatility after equity market openings. We also find that financial liberalizations are associated with declines in the ratio of consumption growth volatility to GDP growth volatility, suggesting improved risk sharing. Our results are weaker for liberalizing emerging markets but we never observe a significant increase in real volatility. Moreover, we demonstrate significant differences in the volatility response depending on the size of the banking and government sectors and certain institutional factors.

We identify a new channel for the transmission of shocks across international markets. Investor flows to funds domiciled in developed markets force significant changes in these funds' emerging market portfolio allocations. These forced trades or “fire sales” affect emerging market equity prices, correlations, and betas, and are related to but distinct from effects arising purely from fund holdings or from overlapping ownership of emerging markets in fund portfolios. A simple model and calibration exercise highlight the importance to these findings of “push” effects from funds' domicile countries and “co‐ownership spillover” between markets with overlapping fund ownership.