The Relation between Liquidity Risk and Default Risk in Equity Returns

72 Pages Posted: 9 Aug 2006

See all articles by Maria Vassalou

Maria Vassalou

Centre for Economic Policy Research (CEPR)

Jing Chen

Columbia University - Columbia Business School

Lihong Zhou

Columbia University - Columbia Business School

Date Written: July 16, 2006

Abstract

This paper demonstrates the relative importance of default and liquidity risks in equity returns. While previous studies have shown that both default and liquidity risks affect equity returns, none, to our knowledge, has examined their interrelation and relative importance for equity returns. We consider three alternative liquidity measures: the Pastor-Stambaugh measure, the turnover measure, and the illiquidity ratio measure. The default measure of choice is the one based on Merton's (1974) contingent claims approach. The alternative liquidity measures are very different from each other, but they are all related to our default measure. While we know from past research that low liquidity stocks earn higher returns than high liquidity stocks, we demonstrate here that this is the case only when these stocks also have high default risk, and in no other case. In contrast, high default risk stocks always earn higher returns than low default risk stocks, independently of their liquidity level. Vector autoregressive tests reveal the existence of a two-way causal relation between default risk and stock market returns, which is not present in the case of liquidity. Liquidity risk does not affect the future path of stock market returns. The robustness of these relations remains unaltered when we take into account the correlation of the default and liquidity measures with aggregate stock market volatility. Consistent with previous evidence, the inclusion of default and liquidity variables in popular asset pricing specifications improves a model's performance. However, the improvement is much larger when the included variable is default, rather than liquidity. In the presence of the default variable, the inclusion of a liquidity proxy in an asset pricing specification results in only a marginal improvement of the model's performance. The opposite is not true.

Keywords: Liquidity, Default, Equity Returns

JEL Classification: G11, G12

Suggested Citation

Vassalou, Maria and Chen, Jing and Zhou, Lihong, The Relation between Liquidity Risk and Default Risk in Equity Returns (July 16, 2006). EFA 2006 Zurich Meetings, Available at SSRN: https://ssrn.com/abstract=922622 or http://dx.doi.org/10.2139/ssrn.922622

Maria Vassalou (Contact Author)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Jing Chen

Columbia University - Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

Lihong Zhou

Columbia University - Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

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