Illiquidity and stock returns: cross-section and time-series effects

Abstract

ILLIQUIDITY AND STOCK RETURNS: Cross-Section and Time-Series Effects by Yakov Amihud* This version: August 2000 Please do not quote without the author’s permission Comments are welcome *Stern School of Business, New York University, New York 10012, NY. E-mail: yamihud@stern.nyu.edu I thank Haim Mendelson for valuable comments and suggestions and Viral Acharya for competent research assistance and comments. Helpful comments were also received from Michael Brennan, Martin Gruber and Richard Roll. Copyright © 2000 By Yakov Amihud ILLIQUIDITY AND STOCK RETURNS: Cross-Section and Time-Series Effects 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 “risk premium”). 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 “small firm effect” over time. The impact of market illiquidity on stock excess return suggests the existence of illiquidity premium and helps explain the equity premium puzzle. 2 1. Introduction The hypothesis on the return-liquidity relationship is that stock expected return is an increasing function of stock illiquidity, …

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