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Siraprapa Watakit

5502310013

Illiquidity and stock returns:cross-section and time-series effects

Yakov Amihud [2002]

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Agenda

Overview of The Paper

Contribution

Cross-section relationship between illiquidity and stock return

The effect over time of market illiquidity onexpected stock excess return

Conclusion

2

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Overview of The Paper3

The paper explains that, not onlymarket risk factor but also

illiquidity factor contributes to stock expected returns

The illiquidity factor has positive correlation with expected returns

The effect of illiquidity is especiallystrong in small stocks

Using daily and monthly; The results show that both across stocks

and over time, expected stock returns are an increasing function of

expected illiquidity.

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Contribution4

The use of daily/monthly data and new tests to find the relationship

between returns and illiquidity.

The results are consistent with previous paper finding

This approach enables to construct long time series of illiquidity

In term of time-series effect: the paper shows that

the expected market illiquidity varies over time

size effect is related to changes in market illiquidity

The illiquidity is still significant when adding other variables e.g.

default yield, term yield, January effect and etc.

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Introduction - ILLIQ5

The relationship between return and illiquidity has been studied and

foundthat return increases in illiquidity

There are many proxies for illiquidity

Using market microstructure data

Bid-Ask spread

Transaction-by-Transaction market impact

probability of information based trading

Using daily/monthly

ratio of absolute returns over dollar value

Turnover i.e. trading volume over outstanding

shares

require a lot of

data, not widely

available, different

across marketexchange, not long

enough

easy to find, long

period of data, and

also positively

related to other

measurement from

market micro data

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Cross-section relationship between

illiquidity and stock return6

Measures of illiquidity: The average illiquidity of stocki in yearyis calculated as

Empirical methodology: Using NYSE 1963-1997 monthly anddaily with Fama-Macbeth Method(1973), returns are adjusted fordelisting bias

Monthly regression of (2) over 1964-1997 produce 408 estimatesof kjmy. These monthly estimates are averaged and tests ofstatistical significance are performed

Characteristic j of stock i

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Cross-section relationship between

illiquidity and stock return7

Stock Characteristic

Liquidity variables: from(1) Theaverage market illiquidity

across stocks in each year is calculated as

The mean adjusted value of ILLIQiy to be used in (2) is

Risk variables: Rank stocks by SIZE and form 10 portfolios.

Calculate each portfolio return of each year, Rpty ,assuming

equally-weighted and then regress for BETApy

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8

Stock Characteristic(continue)

Additional variables

Dividend Yield

Size

SDRET

R100iy the return on stock i during the last 100 days of year

y

R100YR the return on stock i over the rest of the period,

between the beginning of the year and 100 days before its end

Cross-section relationship between

illiquidity and stock return

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Table 2:monthly cross-sectional regression

Cross-section relationship between

illiquidity and stock return

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The effect over time of market illiquidity

on expected stock excess return10

If investors anticipate higher market illiquidity, they will price

stocks so that they generate higher expected return.

risk premium, includes a premium for illiquidity

Transaction costs and price impact

Brokerage fees(bid ask spread) for T-Bill is much cheaper than

stocks

Investor can trade very large amount of T-Bill without price

impact but block transaction in stocks result in price impact

imply high transaction cost

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11

Estimation procedure and results

Expected illiquidity is estimated by an autoregressive model, and

this estimate is employed to test two hypotheses:

(i) ex ante stock excess return is an increasing function of

expected illiquidity

(ii) unexpected illiquidity has a negative effect on

contemporaneous unexpected stock return.

The effect over time of market illiquidity

on expected stock excess return

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Table 3

Decreasing in

size

increasing in

size

The effect over time of market illiquidity

on expected stock excess return

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Market illiquidity and excess returns on size-based portfolios

The existence of two effects on stock return when expected market

illiquidity rises:

(a) A decline in stock price and a rise in expected return,

common to all stocks.

(b) Substitution from less liquid to more liquid stocks

(flight to liquidity).

For low-liquidity stocks the two effects are complementary, both

affecting stock returns in the same direction.

For liquid stocks the two effects work in opposite directions,

increases in demand for liquid stocks mitigates the price decline

The effect over time of market illiquidity

on expected stock excess return

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Table 4: monthly data

The effect over time of market illiquidity

on expected stock excess return

Significant

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Illiquidity effect, controlling for the effects of bond yield premiums

Table 5

The effect over time of market illiquidity

on expected stock excess return

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Conclusion16

Using daily/monthly data which are easy to acquire, we can find the

illiquidity effect in both cross-section and time-series

The effect of illiquidity is strong in small stocks

After controlling January effect and bond yield premium, the

illiquidity effect is still significant