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Liquidity Risk and Expected Stock Returns

Author

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  • LUBOŠ PÁSTOR
  • ROBERT F. STAMBAUGH
Abstract
This study investigates whether marketwide liquidity is a state variable important for asset pricing. We find that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Our monthly liquidity measure, an average of individual-stock measures estimated with daily data, relies on the principle that order flow induces greater return reversals when liquidity is lower. From 1966 through 1999, the average return on stocks with high sensitivities to liquidity exceeds that for stocks with low sensitivities by 7.5 percent annually, adjusted for exposures to the market return as well as size, value, and momentum factors. Furthermore, a liquidity risk factor accounts for half of the profits to a momentum strategy over the same 34-year period.
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Suggested Citation

  • Luboš Pástor & Robert F. Stambaugh, "undated". "Liquidity Risk and Expected Stock Returns," CRSP working papers 531, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    • Handle: RePEc:wop:chispw:531
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    File URL: http://gsbwww.uchicago.edu/fac/finance/papers/liquidity.pdf
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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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