Sentiment Versus Liquidity Pricing Effects in the Cross-Section of UK Stock Returns

Abstract

This study examines the asset pricing role of ‘sentiment risk’ in stock returns in the case of the UK stock market. We define sentiment risk as the sensitivity of stock returns to investor sentiment in financial markets. We incorporate a broad range of financial market variables in measuring financial conditions and use this as a proxy for market-wide investor sentiment. The paper distinguishes between rational and irrational (noisy) investor sentiment. Initial findings indicate a strong role for rational sentiment risk in the returns of FTSE All Share stocks. However, our paper makes a key contribution by identifying that this evidence largely disappears after controlling for the liquidity risk features of stocks. No evidence of sentiment risk pricing is found among the subgroups of FTSE 250 and FTSE 100 stocks. More generally, our findings point to a strong relation between sentiment risk and liquidity risk in returns and the need for careful disentangling of sentiment versus liquidity effects.

Keywords: Sentiment risk, asset pricing, stock returns, financial conditions

JEL Classification: G11, G12, G14