Illiquidity and Stock Returns – II: Cross-Section and Time-Series Effects
34 Pages Posted: 19 Mar 2018
Date Written: March 12, 2018
Lou and Shu (Review of Financial Studies, 2017) decompose Amihud’s (2002) illiquidity measure (ILLIQ) into two terms and claim that the average of inverse dollar trading volume (IDVOL) is sufficient to explain the cross-section of expected returns. We show two problems with their analysis. First, it hinges on an error in decomposing ILLIQ. They omit a term related to the covariance between volatility and trading volume which we show has significant effects on both the cross-section of expected stock returns and on the time-series of realized market returns. Second, the market IDVOL performs much worse than market ILLIQ in explaining the effect of illiquidity shocks on the time-series of realized market returns. IDVOL is also shown to incorrectly depict the liquidity crises of 1987 and 2008 while ILLIQ depicts them correctly.
Keywords: Illiquidity, Stock Returns, Cross-Section, Time-Series, Trading Volume
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