Systematic Liquidity Risk and Stock Price Reaction to Shocks: Evidence from London Stock Exchange

Abstract

This study examines the relationship between systematic liquidity risk and stock price reaction to large one-day price changes (or shocks). We base our analysis on 642 constituents of the FTSEALL share index. Our overall results are consistent with Brown et al.’s (1988) uncertain information hypothesis. However, further analysis suggests that stocks with low systematic risk react efficiently to shocks of different signs and magnitudes whereas stocks with high systematic liquidity risk overreact to negative shocks and underreact to positive shocks. Thus, trading on price patterns following shocks may not be profitable, as it involves taking substantial systematic liquidity risk.

Keywords: shocks, systematic liquidity risk, overreaction, underreaction

JEL Classification: G1