Stock Returns and the Volatility of Liquidity

Abstract

This paper offers a rational explanation for the puzzling empirical fact that stock returns decrease 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 multi-period 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. * We are grateful for the helpful comments of Dong

Investigating banks’ financial structure on profitability and price volatility of banks’ shares: Evidence from Tehran Stock Exchange

“…In addition, the study has determined that there was a positive relationship between equity ratio and return on assets and there was a positive relationship between equity ratio and price volatility when the level of significance was five percent. The results of the survey are consistent with findings of Abor (2005), Cetorelli and Gambera (2001), Gan (2004), Niresh (2012), Niresh (2012) and Pereira and Zhang (2010).…”

“…In addition, information sharing was believed to increase the volume of lending when adverse selection becomes severe that safe borrowers drop out of the market. According to Pereira and Zhang (2010), stock returns decrease with an increase in the volatility of liquidity. Rajan and Zingales (1995) studied the determinants of capital structure choice by analyzing the financing decisions of public companies in the major industrialized countries.…”

Why does higher variability of trading activity predict lower expected returns?

“…In untabulated results, I hypothesize and confirm that the negative relation between variability of the Amihud measure and future returns documented in Pereira and Zhang (2010) is due to the mechanically positive correlation between turnover variability and variability of the Amihud measure (both turnover and the Amihud measure are ratios that include trading volume). In portfolio sorts, I find that the negative relation between the Amihud measure and future alphas is marginally significant at about 20 bp per month and dissipates completely after controlling for FVIX.…”

“…I conclude that while the changes in the betas of high turnover variability firms predicted by my theory are large and economically important, the use of the ICAPM is necessary to explain the turnover variability effect. Pereira and Zhang (2010) argue that the variability of trading activity is negatively related to future returns because higher variability of trading activity implies higher variability of price impact, and higher variability of price impact means a higher chance to trade with a lower price impact. Pereira and Zhang (2010) assume that investors in firms with high turnover variability can wait out the periods of low liquidity and use the periods of high liquidity that firms with more variable liquidity are more likely to have.…”

Stock liquidity on the Warsaw Stock Exchange in the 21st century: Time-series and cross-sectional dependencies

“…Amihud, Mendelson, 1986;Amihud, 2002;Pastor, Stambaugh, 2003;Acharya, Pedersen, 2005;Amihud et al, 2015), portfolio allocation (see e.g. Longstaff, 2001;Garleanu, 2009;Gonzalez, Rubio, 2007;Pereira, Zhang, 2010;Garsztka, 2012;Garleanu, Pedersen, 2013) as well as on risk management. In general, liquidity denotes the ability to trade large quantities of a security quickly, at low cost, and without incurring an unfavourable price impact (Pastor, Stambaugh, 2003).…”