Market Illiquidity and Conditional Equity Premium

44 Pages Posted: 24 Jan 2010 Last revised: 9 Oct 2016

See all articles by Hui Guo

Hui Guo

University of Cincinnati - Department of Finance - Real Estate

Sandra Mortal

University of Alabama - Culverhouse College of Commerce & Business Administration

Robert Savickas

George Washington University - School of Business - Department of Finance

Robert Wood

University of Memphis - Fogelman College of Business and Economics

Date Written: September 1, 2016

Abstract

We examine the time-series relation between aggregate bid-ask spreads and conditional equity premium. We document that average market-wide relative effective bid-ask spreads forecast aggregate market returns only when controlling for average idiosyncratic variance. This control allows us to document the otherwise elusive relation between illiquidity and returns. The reason is that idiosyncratic variance correlates positively with spreads but has a negative effect on conditional equity premium, causing an omitted variable bias. Our results are robust to standard return predictors, alternative illiquidity measures, and out of sample tests. These findings are important because they provide strong support for the literature’s conjecture that market-wide liquidity is an important asset-pricing risk factor.

Keywords: liquidity, stock return predictability, conditional equity premium

JEL Classification: G1

Suggested Citation

Guo, Hui and Mortal, Sandra and Savickas, Robert and Wood, Robert A., Market Illiquidity and Conditional Equity Premium (September 1, 2016). Available at SSRN: https://ssrn.com/abstract=1540557 or http://dx.doi.org/10.2139/ssrn.1540557

Hui Guo (Contact Author)

University of Cincinnati - Department of Finance - Real Estate ( email )

College of Business
418 Carl H. Lindner Hall
Cincinnati, OH 45221
United States
513.556.7077 (Phone)
513.556.0979 (Fax)

HOME PAGE: http://homepages.uc.edu/~guohu/

Sandra Mortal

University of Alabama - Culverhouse College of Commerce & Business Administration ( email )

Culverhouse College of Business
Tuscaloosa, AL 35487-0223
United States

Robert Savickas

George Washington University - School of Business - Department of Finance ( email )

Funger Hall, Suite 501R
2201 G Street, N.W.
Washington, DC 20052
United States
202-994-8936 (Phone)
202-994-5014 (Fax)

HOME PAGE: http://savickas.net/

Robert A. Wood

University of Memphis - Fogelman College of Business and Economics ( email )

Memphis, TN 38152
United States
901-678-2670 (Phone)
901-678-3006 (Fax)

HOME PAGE: http://www.people.memphis.edu/~rwood/

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