Cross-sectional Variation in Stock Returns: Liquidity and Idiosyncratic Risk

Abstract:     
The roles played by idiosyncratic risk and liquidity in determining stock returns have recently received a great deal of attention. However, recent empirical tests have not examined the interaction between these two factors. As others have shown (and this paper confirms) stocks idiosyncratic risk and liquidity are negatively correlated. To what extent then is each variable responsible for the observed cross sectional patterns in stock returns? Overall, using monthly data, the paper finds that stock returns are increasing with the level of idiosyncratic risk and decreasing in a stock's liquidity. However, while both liquidity and idiosyncratic risk play a role in determining returns, the impact of idiosyncratic risk is much stronger and often eliminates liquidity's explanatory power. The point estimates indicate that a one standard deviation change in idiosyncratic risk has between 2.5 and 8 times the impact of a corresponding change in liquidity on cross sectional expected returns.

Keywords: idiosyncratic risk, liquidity, stock returns

JEL Classifications: G12

Working Paper Series