Cross-Sectional Variation in Stock Returns: Liquidity and Idiosyncratic Risk

51 Pages Posted: 23 Apr 2005

See all articles by Matthew I. Spiegel

Matthew I. Spiegel

Yale University - Yale School of Management, International Center for Finance

Xiaotong Wang

Yale University - International Center for Finance; Yale School of Management

Date Written: September 8, 2005

Abstract

The roles played by idiosyncratic risk and liquidity in determining stock returns have recently received a great deal of attention. However, recent empirical tests have not examined the interaction between these two factors. As others have shown (and this paper confirms) stocks idiosyncratic risk and liquidity are negatively correlated. To what extent then is each variable responsible for the observed cross sectional patterns in stock returns? Overall, using monthly data, the paper finds that stock returns are increasing with the level of idiosyncratic risk and decreasing in a stock's liquidity. However, while both liquidity and idiosyncratic risk play a role in determining returns, the impact of idiosyncratic risk is much stronger and often eliminates liquidity's explanatory power. The point estimates indicate that a one standard deviation change in idiosyncratic risk has between 2.5 and 8 times the impact of a corresponding change in liquidity on cross sectional expected returns.

Keywords: idiosyncratic risk, liquidity, stock returns

JEL Classification: G12

Suggested Citation

Spiegel, Matthew I. and Wang, Xiaotong, Cross-Sectional Variation in Stock Returns: Liquidity and Idiosyncratic Risk (September 8, 2005). Yale ICF Working Paper No. 05-13; EFA 2005 Moscow Meetings Paper. Available at SSRN: https://ssrn.com/abstract=709781

Matthew I. Spiegel (Contact Author)

Yale University - Yale School of Management, International Center for Finance ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
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203-432-6017 (Phone)
203-432-8931 (Fax)

HOME PAGE: http://som.yale.edu/~spiegel

Xiaotong Wang

Yale University - International Center for Finance ( email )

Box 208200
New Haven, CT 06520
United States

Yale School of Management

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

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