Market Microstructure and Asset Pricing: On the Compensation for Market Illiquidity in Stock Returns

Abstract:     
Models of price formation in securities markets suggest that privately informed investors are a significant source of market illiquidity. Since illiquidity increases the round-trip trading cost of an investor, this implies that uninformed investors will demand higher rates of return from securities in which informational asymmetries are more severe. In this paper we derive a simple relationship between expected stock returns and market illiquidity in a model with a single representative investor. Using CRSP data for the period 1984-1992, and ISSM intraday data for the year 1988, we investigate the empirical relation between stock returns and measures of market illiquidity. We find a significant relation between required rates of return and our measure of market illiquidity using two types of test. First, following Amihud and Mendelson (1986), we control for the effects of firm size and systematic risk, as well as the quoted spread; and secondly, following Fama and French (1993), we adjust for risk factors related to the overall market, firm size, and the book-to-market ratio.

JEL Classifications: G10, G13, G14

Working Paper Series