Expected Returns and Markov-Switching Illiquidity

40 Pages Posted: 6 Mar 2007  

Tyler R. Henry

Miami University

John T. Scruggs

Barclays Global Investors

Date Written: March 1, 2007

Abstract

Recent theoretical models imply that liquidity is fragile: financial markets are liquid in some equilibria and illiquid in others. This paper employs an intuitively appealing Markov-switching regime model to investigate the episodic nature of stock market illiquidity and the intertemporal relation between illiquidity risk and expected stock returns. We introduce a two-state Markov-switching regime model for stock market illiquidity, returns and volatility. We find evidence of a significant illiquidity risk premium; the expected stock return is positively related to the conditional probability of an illiquid regime. By combining the Markov-switching model with a log-linear model for stock returns, we derive a tractable expression for the illiquidity feedback effect. Modeling the illiquidity feedback effect is critical to understanding the relation between realized stock returns, expected returns and Markov-switching illiquidity. We develop a flexible Bayesian Markov chain Monte Carlo (MCMC) approach for estimating and comparing models.

Keywords: Illiquidity, Risk premium, Markov-switching regime model

JEL Classification: G12, C11, C15, C32

Suggested Citation

Henry, Tyler R. and Scruggs, John T., Expected Returns and Markov-Switching Illiquidity (March 1, 2007). Available at SSRN: https://ssrn.com/abstract=967462 or http://dx.doi.org/10.2139/ssrn.967462

Tyler R. Henry

Miami University ( email )

Farmer School of Business
800 E. High Street
Oxford, OH 45056
United States
5135292272 (Phone)

John T. Scruggs (Contact Author)

Barclays Global Investors ( email )

45 Fremont Street
San Francisco, CA 94105
United States
415-817-6115 (Phone)

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