Liquidity Risk and Expected Stock Returns
by Lubo Pástor of the University of Chicago, and
Abstract: This study investigates whether market-wide liquidity is a state variable important for asset pricing. We find that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Our monthly liquidity measure, an average of individual-stock measures estimated with daily data, relies on the principle that order flow induces greater return reversals when liquidity is lower. Over a 34-year period, the average return on stocks with high sensitivities to liquidity exceeds that for stocks with low sensitivities by 7.5% annually, adjusted for exposures to the market return as well as size, value, and momentum factors.
Keywords: asset pricing, liquidity risk, expected returns.
Published in: Journal of Political Economy, Vol. 111, No. 3, (June 2003), pp. 642-685.