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

Abstract

Introduction The hypothesis on the relationship between stock return and stock liquidity is that return increases in illiquidity, as proposed by Amihud and Mendelson (1986). The positive return--illiquidity relationship has been examined across stocks in a number of studies. This study examines this relationship over time. It proposes that over time, the ex ante stock excess return is increasing in the expected illiquidity of the stock market . The illiquidity measure employed here, called ILLIQ , is the daily ratio of absolute stock return to its dollar volume, averaged over some period. It can be interpreted as the daily price response associated with one dollar of trading volume, thus serving as a rough measure of price impact. There are finer and better measures of illiquidity, such as the bid–ask spread (quoted or effective), transaction-by-transaction market impact, or the probability of information-based trading. These measures, however, require a lot of microstructure data that are not available in many stock markets. And, even when available, the data do not cover very long periods of time. The measure used here enables to construct long time series of illiquidity that are necessary to test the effects over time of illiquidity on ex ante and contemporaneous stock excess return. This would be very hard to do with the finer microstructure measures of illiquidity.

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