Idiosyncratic Volatility of Liquidity and Expected Stock Returns

We show that idiosyncratic liquidity risk is positively priced in the cross-section of stock returns. Our measure of idiosyncratic liquidity volatility is based on a ”market” model for stock liquidity. Idiosyncratic volatility of liquidity is priced in the presence of systematic liquidity risk: the covariance of stock returns with aggregate liquidity, the covariance of stock liquidity with aggregate liquidity, and the covariance of stock liquidity with the market return. Our results are puzzling in light of Acharya and Pedersen (2005) who develop a model in which only systematic liquidity risk affects returns. We thank Kerry Back and seminar participants at the Bank of Canada, Purdue University, Texas A&M University, University of Georgia, and University of Oklahoma for helpful comments and suggestions. KU School of Business, University of Kansas, Lawrence KS 66049, USA.; E-mail: [email protected]. Mays Business School, Texas A&M University, College Station TX 77845, USA.; E-mail: [email protected]. Corresponding author. Krannert School of Management, Purdue University, West Lafayette IN 47906, USA. Tel.: 765 494 4397; E-mail: [email protected]. There is increasing evidence that liquidity affects asset returns. Numerous studies examine the liquidity characteristics of stocks and show that illiquid assets earn higher expected returns. Furthermore, the evidence also shows that the liquidity of individual stocks varies over time. If a stock’s liquidity is very volatile this will increase the uncertainty attached to the stock position and limit the investor’s flexibility at the time he chooses to trade. For example, an investor who needs to reduce his exposure in a stock may have to sell at fire-sale prices or unbalance his portfolio by selling his most liquid securities. In extreme cases, a stock’s liquidity may suddenly dry up eliminating the opportunity for the investor to enter or exit the position at all. Part of the variation in a stock’s liquidity is systematic since it is driven by factors that affect all stocks, such as variation in market-wide liquidity. The sensitivity to aggregate market liquidity creates commonality in the liquidity variation across stocks and most stocks become more (less) liquid when aggregate market liquidity increases (decreases). It seems reasonable that investors might require compensation for being exposed to systematic liquidity variation. Consider, for example, an investor who has experienced a large drop in wealth and must liquidate some assets to raise cash. Since a decline in wealth is likely to occur at times when aggregate liquidity is low, all the assets held by the investor are likely to become less liquid due to commonality. Therefore, the commonality in liquidity is a systematic risk that cannot be diversified away. Since liquidation is costlier when liquidity is low, the investor would require higher expected returns from assets whose liquidity has See, among others, Amihud and Mendelson (1986, 1989), Brennan and Subrahmanyam (1996), Eleswarapu (1997), Brennan, Chordia and Subrahmanyam (1998), Chalmers and Kadlec (1998), Chordia, Roll and Subrahmanyam (2001), Amihud (2002), Hasbrouck (2009), Chordia, Huh, and Subrahmanyam (2009). Persaud (2003) observes that ”there is a broad belief among users of financial liquidity-traders, investors and central bankersthat the principal challenge is not the average level of financial liquidity, but its variability and uncertainty.” The commonality in liquidity has been documented by Huberman and Halka (2001), Chordia, Roll, and Subrahmanyam (2000), and Hasbrouck and Seppi (2001), among others.