Illiquidity and the Measurement of Stock Price Synchronicity

Joachim Gassen · Hollis Ashbaugh Skaife · David Veenman

61 citations0/0 files storedContemporary Accounting Research

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Financial Markets and Investment Strategies Corporate Finance and Governance Auditing, Earnings Management, Governance

Abstract

ABSTRACT This paper demonstrates that measures of stock price synchronicity based on market model R2s are predictably biased downward as a result of stock illiquidity, and that previously employed remedies to correct market model betas for measurement bias do not fix R2. Using a large international sample of firm‐years, we find strong negative and nonlinear relations between illiquidity and R2 across countries, across firms, and over time. Because variables of interest frequently relate to illiquidity as well, we illustrate the consequences of not controlling for illiquidity in synchronicity research. More generally, we demonstrate the importance of using nonlinear control variable methods. Overall, we conclude that the illiquidity‐driven measurement bias in R2 provides an explanation for why prior research finds low‐R2 firms to have weak information environments, and suggest future research carefully evaluate the sensitivity of its results to nonlinear controls for illiquidity.

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References

1973Risk, Return, and Equilibrium: Empirical Tests 2002Illiquidity and stock returns: cross-section and time-series effects 1985Continuous Auctions and Insider Trading 1985Bid, ask and transaction prices in a specialist market with heterogeneously informed traders 1980On the Impossibility of Informationally Efficient Markets 1986Asset pricing and the bid-ask spread 1997The Econometrics of Financial Markets 1991Disclosure, Liquidity, and the Cost of Capital

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