Liquidity Risk and Expected Stock Returns
University of Chicago, National Bureau of Economic Research, and Centre for Economic Policy Research
Robert F Stambaugh
University of Pennsylvania and National Bureau of Economic Research
This study investigates whether marketwide liquidity is a state variable important for asset pricing. We ﬁnd that expected stock returns are related cross-sectionally to the sensitivities of returns to ﬂuctuations in aggregate liquidity. Our monthly liquidity measure, an average of individual-stock measures estimated with daily data, relies on the principle that order ﬂow induces greater return reversals when liquidity is lower. From 1966 through 1999, the average return on stocks with high sensitivities to liquidity exceeds that for stocks with low sensitivities by 7.5 percent annually, adjusted for exposures to the market return as well as size, value, and momentum factors. Furthermore, a liquidity risk factor accounts for half of the proﬁts to a momentum strategy over the same 34-year period.
Research support from the Center for Research in Security Prices and the James S. Kemper Faculty Research Fund at the Graduate School of Business, University of Chicago, is gratefully acknowledged (Pastor). We are grateful for comments from Nick Barberis, ´
John Campbell, Tarun Chordia, John Cochrane (the editor), George Constantinides, Doug Diamond, Andrea Eisfeldt, Gene Fama, Simon Gervais, David Goldreich, Gur Huberman, Michael Johannes, Owen Lamont, Andrew Metrick, Mark Ready, Hans Stoll, Dick Thaler, Rob Vishny, Tuomo Vuolteenaho, Jiang Wang, and two anonymous referees, as well as workshop participants at Columbia University, Harvard University, New York University, Stanford University, University of Arizona, University of California at Berkeley, University of Chicago, University of Florida, University of Pennsylvania, Washington University, the Review of Financial Studies Conference on Investments in Imperfect Capital Markets at Northwestern University, the Fall 2001 NBER Asset Pricing meeting, and the 2002 Western Finance Association meetings.
[Journal of Political Economy, 2003, vol. 111, no. 3]
᭧ 2003 by The University of Chicago. All rights reserved. 0022-3808/2003/11103-0006$10.00
In standard asset pricing theory, expected stock returns are related crosssectionally to returns’ sensitivities to state variables with pervasive effects on investors’ overall welfare. A security whose lowest returns tend to accompany unfavorable shifts in that welfare must offer additional compensation to investors for holding the security. Liquidity appears to be a good candidate for a priced state variable. It is often viewed as an important feature of the investment environment and macroeconomy, and recent studies ﬁnd that ﬂuctuations in various measures of liquidity are correlated across assets.1 This empirical study investigates whether marketwide liquidity is indeed priced. That is, we ask whether crosssectional differences in expected stock returns are related to the sensitivities of returns to ﬂuctuations in aggregate liquidity. It seems reasonable that many investors might require higher expected returns on assets whose returns have higher sensitivities to aggregate liquidity. Consider, for example, any investor who employs some form of leverage and faces a margin or solvency constraint, in that if his overall wealth drops sufﬁciently, he must liquidate some assets to raise cash. If he holds assets with higher sensitivities to liquidity, then such liquidations are more likely to occur when liquidity is low, since drops in his overall wealth are then more likely to accompany drops in liquidity. Liquidation is costlier when liquidity is lower, and those greater costs are especially unwelcome to an investor whose wealth has already dropped and who thus has higher marginal utility of wealth. Unless the investor expects...
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