The Volatility of Liquidity and Expected Stock Returns

45 Pages Posted: 18 Mar 2011

See all articles by Ralitsa Petkova

Ralitsa Petkova

Case Western Reserve University - Department of Banking & Finance

Ferhat Akbas

University of Illinois at Chicago

Will J. Armstrong

Texas Tech University - Area of Finance

Date Written: March 15, 2011

Abstract

We document a positive relation between the volatility of liquidity and expected returns. Our measure of liquidity is based on Amihud (2002) and its volatility is measured using daily data. We show that the volatility of liquidity effect is different from previously documented liquidity risks: the covariance of stock returns with aggregate liquidity, the covariance of stock liquidity with aggregate liquidity, and the covariance of stock liquidity with the market return. The positive correlation between the volatility of liquidity and expected returns suggests that risk averse investors require a risk premium for holding stocks that have high variation in liquidity. Higher variation in liquidity implies that a stock may become illiquid with higher probability at a time when it is traded. This is important for investors who face an immediate liquidity need and are not able to wait for periods of high liquidity to sell. Overall, our results suggest that besides the mean level of liquidity, the second moment of liquidity also matters in the cross-section of stock returns.

Suggested Citation

Petkova, Ralitsa and Akbas, Ferhat and Armstrong, Will J., The Volatility of Liquidity and Expected Stock Returns (March 15, 2011). Available at SSRN: https://ssrn.com/abstract=1786991 or http://dx.doi.org/10.2139/ssrn.1786991

Ralitsa Petkova (Contact Author)

Case Western Reserve University - Department of Banking & Finance ( email )

10900 Euclid Ave.
Cleveland, OH 44106-7235
United States

Ferhat Akbas

University of Illinois at Chicago ( email )

1200 W Harrison St
Chicago, IL 60076
United States

Will J. Armstrong

Texas Tech University - Area of Finance ( email )

Lubbock, TX 79409
United States

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