Stock Liquidity Risk and the Cross-Sectional Earnings-Returns Relation
Forthcoming, Journal of Business Finance & Accounting, Volume 43, Issue 9-10.
34 Pages Posted: 12 Oct 2016
Date Written: October 11, 2016
We argue that a higher sensitivity to aggregate market-wide liquidity shocks (i.e. a higher liquidity risk) implies a tendency for a stock’s price to converge to fundamentals. We test this intuition within the framework of the earnings-returns relation. We find a positive liquidity risk effect on the relation between return and expected change in earnings. This effect on the earnings-returns relation is distinct from the negative effect observed for stock illiquidity level. Notably, the liquidity risk effect is evident (absent) during periods of neutral/low (high) aggregate market liquidity. We also show that the liquidity risk effect is dominant in firms that: (a) are of intermediate size; (b) are of intermediate book-to-market; and (c) are profit making.
Keywords: Stock liquidity, Risk, Earnings-Returns relation
JEL Classification: G12
Suggested Citation: Suggested Citation