Market Microstructure and Asset Pricing: On the Compensation for Market Illiquidity in Stock Returns

London Business School Institute of Finance and Accounting Working Paper 190

Posted: 6 Sep 1999

See all articles by Michael J. Brennan

Michael J. Brennan

University of California, Los Angeles (UCLA) - Finance Area

Avanidhar Subrahmanyam

University of California, Los Angeles (UCLA) - Finance Area; Institute of Global Finance, UNSW Business School; Financial Research Network (FIRN)

Abstract

Models of price formation in securities markets suggest that privately informed investors are a significant source of market illiquidity. Since illiquidity increases the round-trip trading cost of an investor, this implies that uninformed investors will demand higher rates of return from securities in which informational asymmetries are more severe. In this paper we derive a simple relationship between expected stock returns and market illiquidity in a model with a single representative investor. Using CRSP data for the period 1984-1992, and ISSM intraday data for the year 1988, we investigate the empirical relation between stock returns and measures of market illiquidity. We find a significant relation between required rates of return and our measure of market illiquidity using two types of test. First, following Amihud and Mendelson (1986), we control for the effects of firm size and systematic risk, as well as the quoted spread; and secondly, following Fama and French (1993), we adjust for risk factors related to the overall market, firm size, and the book-to-market ratio.

JEL Classification: G10, G13, G14

Suggested Citation

Brennan, Michael John and Subrahmanyam, Avanidhar, Market Microstructure and Asset Pricing: On the Compensation for Market Illiquidity in Stock Returns. London Business School Institute of Finance and Accounting Working Paper 190. Available at SSRN: https://ssrn.com/abstract=5484

Michael John Brennan

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825 3587 (Phone)
310-206 8419 (Fax)

Avanidhar Subrahmanyam (Contact Author)

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-5355 (Phone)
310-206-5455 (Fax)

Institute of Global Finance, UNSW Business School

Sydney, NSW 2052
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

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