Disentangling Liquidity and Size Effects in Stock Returns: Evidence from China

Abstract

Both size effect and liquidity effect in stock returns have been documented extensively in the literature. Since firm size and stock liquidity are closely correlated, it is generally difficult to disentangle these two effects. The Chinese stock market offers a unique opportunity to address this issue due to the widespread coexistence of tradable and nontradable shares in listed companies. We find that the size effect of nontradable shares on expected returns persists after controlling for several common liquidity measures as well as the size of tradable shares. However, it is substantially weaker than the size effect of tradable shares. Our results suggest that the negative relation between stock returns and firm size, as normally measured by the size of tradable shares, is a mixture of a genuine size effect and a liquidity effect. We also find that despite many special features of the market environment, Chinese stock returns exhibit cross-sectional patterns strikingly similar to those documented for developed markets.

Keywords: liquidity, size effect, stock returns, Chinese stock market

JEL Classification: G12, G14, G15