Illiquidity and Stock Returns: Cross-Section and Time-Series Effects

doi:10.2139/SSRN.3139180

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Illiquidity and Stock Returns: Cross-Section and Time-Series Effects

Journal Article•DOI•

Illiquidity and Stock Returns: Cross-Section and Time-Series Effects

Yakov Amihud¹•Institutions (1)

New York University¹

01 Jan 2000-Social Science Research Network-

TL;DR: In this paper, the effects of stock illiquidity on stock return have been investigated and it was shown that expected market illiquidities positively affects ex ante stock excess return (usually called risk premium) over time.

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Abstract: New tests are presented on the effects of stock illiquidity on stock return. Over time, expected market illiquidity positively affects ex ante stock excess return (usually called â¬Srisk premiumâ¬?). This complements the positive cross-sectional return-illiquidity relationship. The illiquidity measure here is the average daily ratio of absolute stock return to dollar volume, which is easily obtained from daily stock data for long time series in most stock markets. Illiquidity affects more strongly small firms stocks, suggesting an explanation for the changes â¬Ssmall firm effectâ¬? over time. The impact of market illiquidity on stock excess return suggests the existence of illiquidity premium and helps explain the equity premium puzzle.

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Journal Article•DOI•

Mandatory IFRS Reporting around the World: Early Evidence on the Economic Consequences

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Holger Daske¹, Luzi Hail², Christian Leuz³, Rodrigo S. Verdi•Institutions (3)

University of Mannheim¹, University of Pennsylvania², University of Chicago³

01 Dec 2008-Journal of Accounting Research

TL;DR: In this article, the authors examine the economic consequences of mandatory International Financial Reporting Standards (IFRS) reporting around the world and find that market liquidity increases around the time of the introduction of IFRS.

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Abstract: This paper examines the economic consequences of mandatory International Financial Reporting Standards (IFRS) reporting around the world. We analyze the effects on market liquidity, cost of capital, and Tobin's q in 26 countries using a large sample of firms that are mandated to adopt IFRS. We find that, on average, market liquidity increases around the time of the introduction of IFRS. We also document a decrease in firms' cost of capital and an increase in equity valuations, but only if we account for the possibility that the effects occur prior to the official adoption date. Partitioning our sample, we find that the capital-market benefits occur only in countries where firms have incentives to be transparent and where legal enforcement is strong, underscoring the central importance of firms' reporting incentives and countries' enforcement regimes for the quality of financial reporting. Comparing mandatory and voluntary adopters, we find that the capital market effects are most pronounced for firms that voluntarily switch to IFRS, both in the year when they switch and again later, when IFRS become mandatory. While the former result is likely due to self-selection, the latter result cautions us to attribute the capital-market effects for mandatory adopters solely or even primarily to the IFRS mandate. Many adopting countries make concurrent efforts to improve enforcement and governance regimes, which likely play into our findings. Consistent with this interpretation, the estimated liquidity improvements are smaller in magnitude when we analyze them on a monthly basis, which is more likely to isolate IFRS reporting effects.

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1,986 citations

Journal Article•DOI•

Value and Momentum Everywhere: Value and Momentum Everywhere

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Clifford S. Asness, Tobias J. Moskowitz, Lasse Heje Pedersen

01 Jun 2013-Journal of Finance

1,407 citations

Book Chapter•DOI•

Market Liquidity: Asset Pricing with Liquidity Risk

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Yakov Amihud, Haim Mendelson, Lasse Heje Pedersen

01 Jan 2012

TL;DR: In this paper, a simple equilibrium model with liquidity risk is proposed, where a security's required return depends on its expected liquidity as well as on the covariances of its own return and liquidity with the market return.

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Abstract: This paper solves explicitly a simple equilibrium model with liquidity risk. In our liquidityadjusted capital asset pricing model, a security s required return depends on its expected liquidity as well as on the covariances of its own return and liquidity with the market return and liquidity. In addition, a persistent negative shock to a security s liquidity results in low contemporaneous returns and high predicted future returns. The model provides a unified framework for understanding the various channels through which liquidity risk may affect asset prices. Our empirical results shed light on the total and relative economic significance of these channels and provide evidence of flight to liquidity. r 2005 Elsevier B.V. All rights reserved.

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1,156 citations

Cites background or methods or result from "Illiquidity and Stock Returns: Cros..."

...…between this measure of innovations in market illiquidity and the measure of innovations in liquidity used by Pastor and Stambaugh (2003) is 0:33:13 (The negative sign is due to the fact that Pastor and Stambaugh (2003) measure liquidity, whereas we follow Amihud (2002) in considering illiquidity.)...
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...We follow Amihud (2002) in estimating illiquidity using only daily data from the Center for Research in Security Prices (CRSP)....
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...The model provides a unified theoretical framework that can explain the empirical findings that return sensitivity to market liquidity is priced (Pastor and Stambaugh (2003)), that average liquidity is priced (Amihud and Mendelson (1986)), and that liquidity comoves with returns and predicts future returns (Amihud (2002), Chordia, Roll, and Subrahmanyam (2001), Jones (2001), and Bekaert, Harvey, and Lundblad (2003))....
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...This may help explain the empirical findings of Amihud et al. (1990), Amihud (2002), Chordia et al. (2001a), Jones (2001), and Pastor and Stambaugh (2003) in the U.S. stock market, and of Bekaert et al. (2003) in emerging markets....
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...Amihud (2002) finds that illiquidity predicts excess return both for the market and for size-based portfolios, and Bekaert et al. (2003) find that illiquidity predicts returns in emerging markets....
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Journal Article•DOI•

Hedge Fund Activism, Corporate Governance, and Firm Performance

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Alon Brav¹, Alon Brav², Wei Jiang³, Wei Jiang², Randall S. Thomas⁴, Frank Partnoy⁵ - Show less +2 more•Institutions (5)

Duke University¹, National Bureau of Economic Research², Columbia University³, Vanderbilt University⁴, University of California, Berkeley⁵

01 May 2008-Social Science Research Network

TL;DR: In this article, the authors used a large hand-collected dataset from 2001 to 2006 to find that hedge funds in the U.S. propose strategic, operational, and financial remedies and attain success or partial success in two thirds of the cases.

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Abstract: Using a large hand-collected dataset from 2001 to 2006, we find that activist hedge funds in the U.S. propose strategic, operational, and financial remedies and attain success or partial success in two thirds of the cases. Hedge funds seldom seek control and in most cases are nonconfrontational. The abnormal return around the announcement of activism is approximately 7%, with no reversal during the subsequent year. Target firms experience increases in payout, operating performance, and higher CEO turnover after activism. Our analysis provides important new evidence on the mechanisms and effects of informed shareholder monitoring.

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1,134 citations

Posted Content•

Idiosyncratic Risk and the Cross-Section of Expected Stock Returns

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Fangjian Fu¹•Institutions (1)

Singapore Management University¹

01 Jan 2009-Social Science Research Network

TL;DR: Using the exponential GARCH models to estimate expected idiosyncratic volatilities, Zhang et al. as mentioned in this paper found a significantly positive relation between the estimated conditional idiosyncratic VOLatilities and expected returns.

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Abstract: Theories such as Merton (1987, Journal of Finance) predict a positive relation between idiosyncratic risk and expected return when investors do not diversify their portfolio. Ang, Hodrick, Xing, and Zhang (2006, Journal of Finance 61, 259-299) however find that monthly stock returns are negatively related to the one-month lagged idiosyncratic volatilities. I show that idiosyncratic volatilities are time-varying and thus their findings should not be used to imply the relation between idiosyncratic risk and expected return. Using the exponential GARCH models to estimate expected idiosyncratic volatilities, I find a significantly positive relation between the estimated conditional idiosyncratic volatilities and expected returns. Further evidence suggests that Ang et al.'s findings are largely explained by the return reversal of a subset of small stocks with high idiosyncratic volatilities.

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877 citations

Cites background or result from "Illiquidity and Stock Returns: Cros..."

...Amihud and Mendelson (1986) is among the first to propose a role for transaction costs in asset pricing, since rational investors select...
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...…equity, Jagadeesh and Titman (1993) for the effects of past returns, Amihud and Mendelson (1986), Brennan and Subrahmanyam (1996), and Amihud (2002) for the effects of liquidity, and Chordia, Subrahmanyam and Anshuman (2001) for the effects of the variance of liquidity on…...
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...12 See, for example, Fama and French (1992) for the effects of size and book-to-market equity, Jagadeesh and Titman (1993) for the effects of past returns, Amihud and Mendelson (1986), Brennan and Subrahmanyam (1996), and Amihud (2002) for the effects of liquidity, and Chordia, Subrahmanyam and Anshuman (2001) for the effects of the variance of liquidity on crosssectional returns....
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...20 Subrahmanyam and Anshuman (2001), Amihud (2002), and Pastor and Stambaugh (2003)....
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...The role played by liquidity is further supported by later studies including Brennan and Subrahmanyam (1996), Datar, Naik and Radcliffe (1998), Chordia, Subrahmanyam and Anshuman (2001), Amihud (2002), and Pastor and Stambaugh (2003)....
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References

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Report•DOI•

A simple, positive semi-definite, heteroskedasticity and autocorrelation consistent covariance matrix

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Whitney K. Newey, Kenneth D. West

01 May 1987-Econometrica

TL;DR: In this article, a simple method of calculating a heteroskedasticity and autocorrelation consistent covariance matrix that is positive semi-definite by construction is described.

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Abstract: This paper describes a simple method of calculating a heteroskedasticity and autocorrelation consistent covariance matrix that is positive semi-definite by construction. It also establishes consistency of the estimated covariance matrix under fairly general conditions.

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18,117 citations

Journal Article•DOI•

The Cross‐Section of Expected Stock Returns

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Eugene F. Fama, Kenneth R. French

01 Jun 1992-Journal of Finance

TL;DR: In this paper, Bhandari et al. found that the relationship between market/3 and average return is flat, even when 3 is the only explanatory variable, and when the tests allow for variation in 3 that is unrelated to size.

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Abstract: Two easily measured variables, size and book-to-market equity, combine to capture the cross-sectional variation in average stock returns associated with market 3, size, leverage, book-to-market equity, and earnings-price ratios. Moreover, when the tests allow for variation in 3 that is unrelated to size, the relation between market /3 and average return is flat, even when 3 is the only explanatory variable. THE ASSET-PRICING MODEL OF Sharpe (1964), Lintner (1965), and Black (1972) has long shaped the way academics and practitioners think about average returns and risk. The central prediction of the model is that the market portfolio of invested wealth is mean-variance efficient in the sense of Markowitz (1959). The efficiency of the market portfolio implies that (a) expected returns on securities are a positive linear function of their market O3s (the slope in the regression of a security's return on the market's return), and (b) market O3s suffice to describe the cross-section of expected returns. There are several empirical contradictions of the Sharpe-Lintner-Black (SLB) model. The most prominent is the size effect of Banz (1981). He finds that market equity, ME (a stock's price times shares outstanding), adds to the explanation of the cross-section of average returns provided by market Os. Average returns on small (low ME) stocks are too high given their f estimates, and average returns on large stocks are too low. Another contradiction of the SLB model is the positive relation between leverage and average return documented by Bhandari (1988). It is plausible that leverage is associated with risk and expected return, but in the SLB model, leverage risk should be captured by market S. Bhandari finds, howev er, that leverage helps explain the cross-section of average stock returns in tests that include size (ME) as well as A. Stattman (1980) and Rosenberg, Reid, and Lanstein (1985) find that average returns on U.S. stocks are positively related to the ratio of a firm's book value of common equity, BE, to its market value, ME. Chan, Hamao, and Lakonishok (1991) find that book-to-market equity, BE/ME, also has a strong role in explaining the cross-section of average returns on Japanese stocks.

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14,517 citations

"Illiquidity and Stock Returns: Cros..." refers background in this paper

...Stock expected returns are negatively related to size (Banz, 1981; Reinganum, 1981; Fama and French, 1992), which is consistent with it being a proxy for liquidity (Amihud and Mendelson, 1986)....
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Journal Article•DOI•

Risk, Return, and Equilibrium: Empirical Tests

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Eugene F. Fama, James D. MacBeth

01 May 1973-Journal of Political Economy

TL;DR: In this article, the relationship between average return and risk for New York Stock Exchange common stocks was tested using a two-parameter portfolio model and models of market equilibrium derived from the two parameter portfolio model.

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Abstract: This paper tests the relationship between average return and risk for New York Stock Exchange common stocks. The theoretical basis of the tests is the "two-parameter" portfolio model and models of market equilibrium derived from the two-parameter portfolio model. We cannot reject the hypothesis of these models that the pricing of common stocks reflects the attempts of risk-averse investors to hold portfolios that are "efficient" in terms of expected value and dispersion of return. Moreover, the observed "fair game" properties of the coefficients and residuals of the risk-return regressions are consistent with an "efficient capital market"--that is, a market where prices of securities

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14,171 citations

"Illiquidity and Stock Returns: Cros..." refers methods in this paper

...The test procedure follows the usual Fama and MacBeth (1973) method....
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Journal Article•DOI•

Continuous Auctions and Insider Trading

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Albert S. Kyle

01 Nov 1985-Econometrica

9,341 citations

"Illiquidity and Stock Returns: Cros..." refers background or result in this paper

...Kyle (1985) proposed that because market makers cannot distinguish between order flow that is generated by informed traders and by liquidity (noise) traders, they set prices that are an increasing function of the imbalance in the order flow which may indicate informed trading....
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...This is consistent with the illiquidity explanation of the small firm effect since illiquidity costs are increasing in the asymmetry of information between traders (see Glosten and Milgrom, 1985; Kyle, 1985 )....
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Journal Article•DOI•

The relationship between return and market value of common stocks

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Rolf W. Banz¹•Institutions (1)

Northwestern University¹

01 Mar 1981-Journal of Financial Economics

TL;DR: Scholes et al. as discussed by the authors examined the relationship between the total market value of the common stock of a firm and its return and found that small firms had higher risk adjusted returns than large firms.

...read moreread less

5,997 citations

"Illiquidity and Stock Returns: Cros..." refers background in this paper

...Stock expected returns are negatively related to size (Banz, 1981; Reinganum, 1981; Fama and French, 1992), which is consistent with it being a proxy for liquidity (Amihud and Mendelson, 1986)....
[...]