The Time-varying Relationship between Illiquidity and Stock Returns: Evidence from Germany
68 Pages Posted: 19 Apr 2021 Last revised: 11 Apr 2022
Date Written: April 18, 2021
This study investigates the structural relationship between illiquidity and excess returns in the German stock market over time. The idea of illiquidity’s impact on asset prices has been challenged in more recent research and we provide further insight into the comprehensive picture of it. We show that illiquidity is still a significant factor when periods of financial turmoil are excluded, and longer expectation formations are considered. Departing from previous studies, we do not examine the relationship between illiquidity and excess returns in exogenously fixed observation periods but rather identify the observation periods endogenously and find the structure that illiquidity is still priced but not in times of financial turmoil. We furthermore apply different variations of Amihud’s illiquidity measure with various adjustments, including a control for Fama-French factors, and our results are robust. When investors incorporate the insight in portfolio decisions by interpreting a structural break of the relation between illiquidity and excess returns as a trading signal significantly better portfolio returns result.
Keywords: Illiquidity, Excess Return, Structural Breaks, Financial turmoil, Asset Pricing, Portfolio Management
JEL Classification: E32, G12
Suggested Citation: Suggested Citation