Liquidity and Expected Returns: Lessons from Emerging Markets
Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)
Campbell R. Harvey
Duke University - Fuqua School of Business; National Bureau of Economic Research (NBER)
Christian T. Lundblad
University of North Carolina Kenan-Flagler Business School
AFA 2004 San Diego Meetings; EFA 2003 Annual Conference Paper No. 690
Given the cross-sectional and temporal variation in their liquidity, emerging equity markets provide an ideal setting to examine the impact of liquidity on expected returns. Our main liquidity measure is a transformation of the proportion of zero daily firm returns, averaged over the month. We find that our liquidity measures significantly predict future returns, whereas alternative measures such as turnover do not.
Consistent with liquidity being a priced factor, unexpected liquidity shocks are positively correlated with contemporaneous return shocks and negatively correlated with shocks to the dividend yield. We consider a simple asset pricing model with liquidity and the market portfolio as risk factors and transaction costs that are proportional to liquidity. The model differentiates between integrated and segmented countries and time periods. Our results suggest that local market liquidity is an important driver of expected returns in emerging markets, and that the liberalization process has not fully eliminated its impact.
Number of Pages in PDF File: 56
Keywords: Liquidity, liquidity risk, asset pricing, emerging markets, market integration, market segmentation, liquidity risk factor, local liquidity, zero returns, bid-ask spread, price impact, liquidity measures
JEL Classification: G12, G14, G15, F30, F36, F02working papers series
Date posted: August 3, 2003
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