Liquidity and Asset Prices in Multiple Markets

Liquidity is generally viewed as a positive characteristic of a traded asset in positive net supply. Ceteris paribus, the higher liquidity of a given asset should be reflected in a higher price or a lower required return. This issue is of particular interest if the same asset is traded in multiple markets. In this setting, apart from the effect of liquidity on pricing in each market, there is the additional question of transmission of these liquidity effects across markets. This paper investigates the liquidity effect in asset pricing by studying the liquidity-premium relationship of an American Depositary Receipt (ADR) and its underlying share in the home market. Using the Amihud (2002) measure, the turnover ratio and trading infrequency as proxies for liquidity, we show that a higher ADR premium is associated with higher ADR liquidity, lower home share liquidity. We measure these effects, in terms of both the levels and changes, in both the premium and the liquidity variables. We find that the liquidity effects remain strong even after we control for firm size and a number of country characteristics, such as the expected change in the foreign exchange rate, the home country and the US stock market performance, as well as several variables measuring the openness and transparency of the home market. JEL Classification: G10, G12, G15