Liquidity and Mispricing

Abstract

Contrary to popular beliefs, the expected return of a strategy that consists of buying illiquid stocks
and shorting liquid ones (i.e., the illiquidity premium) is negative. This finding occurs not only in the
whole cross-section but also in each subsample controlling for size. It can be attributed to overpricing among illiquid stocks and to a lesser extent to underpricing among liquid ones. Economically, arbitrage asymmetry is the driving force behind overpricing among illiquid stocks. Thus, the interplay between illiquidity and mispricing is crucial to explain the cross-section of expected stock returns.

Keywords: Asset pricing, liquidity, arbitrage, mispricing, international stock markets

JEL Classification: G12, G14, G15, F37