Illiquidity and stock returns: cross-section and time-series effects Yakov Amihud [2002]

Siraprapa Watakit 5502310013

Agenda
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Overview of The Paper Contribution Cross-section relationship between illiquidity and stock return The effect over time of market illiquidity on expected stock excess return Conclusion

Overview of The Paper

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The paper explains that, not only market 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 especially strong 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.

Contribution
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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.

Introduction - ILLIQ
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The relationship between return and illiquidity has been studied and found that 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 market exchange, not long enough

easy to find, long period of data, and also positively related to other measurement from market micro data

Cross-section relationship between illiquidity and stock return

Measures of illiquidity: The average illiquidity of stock i in year y is calculated as

Empirical methodology: Using NYSE 1963-1997 monthly and daily with Fama-Macbeth Method(1973), returns are adjusted for delisting bias Characteristic j of stock i

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

Cross-section relationship between illiquidity and stock return

Stock Characteristic Liquidity variables: from(1) The average 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

Cross-section relationship between illiquidity and stock return

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

Table 2:monthly cross-sectional regression

The effect over time of market illiquidity on expected stock excess return
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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

The effect over time of market illiquidity on expected stock excess return
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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

Significant

The effect over time of market illiquidity on expected stock excess return
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Illiquidity effect, controlling for the effects of bond yield premiums

Table 5

Conclusion
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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