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Stock Returns and the Volatility of Liquidity

Published online by Cambridge University Press:  08 June 2010

João Pedro Pereira  and
Harold H. Zhang
João Pedro Pereira
Affiliation:
ISCTE Business School–Lisbon, Finance Department, Av. Forcas Armadas, 1649-026 Lisboa, Portugal. joao.pereira@iscte.pt
Harold H. Zhang
Affiliation:
University of Texas at Dallas, School of Management, PO Box 830688, Richardson, TX 75080. harold.zhang@utdallas.edu
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Abstract

This paper offers a rational explanation for the puzzling empirical fact that stock returns decrease with an increase in the volatility of liquidity. We model liquidity as a stochastic price impact process and define the liquidity premium as the additional return necessary to compensate a multiperiod investor for the adverse price impact of trading. The model demonstrates that a fully rational, utility maximizing, risk-averse investor can take advantage of time-varying liquidity by adapting his trades to the state of liquidity. We provide new empirical evidence supportive of the model.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 45 , Issue 4 , August 2010 , pp. 1077 - 1110
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2010

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