Liquidity level or liquidity risk? A fresh look with new measures

ABSTRACT

Lou and Sadka, in a study that was published in 2011, examine the effect of stock liquidity characteristics on stock performance during the 2008–2009 crisis. Their conclusion is that liquidity risk, and not the liquidity level, explains stock performance during the crisis. Lou and Sadka measure liquidity via Amihud’s illiquidity measure. I construct a new measure of illiquidity, based on transaction-by-transaction price changes and conduct a similar analysis to that in Lou and Sadka. My findings show that, controlling for liquidity risk, the level of liquidity has incremental explanatory power for stock performance during the crisis. My analysis suggests that the level of liquidity and liquidity risk are both important facets of stock liquidity and that there might be an interaction or overlap between the two.

KEYWORDS:

• Asset Pricing
• liquidity
• financial crisis

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Acknowledgments

I am very grateful to Aditya Kaul for prolonged discussions and very useful suggestions. I also thank Ivor Cribben, Pari Veeren, Akiko Watanabe, Masahiro Watanabe, and presentation participants at the University of Alberta for many insightful comments and suggestions.

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

1. For instance, Lou and Shou (2017) show that Amihud’s measure is priced due to the volume component of it, not the return component. Drienko et al. (2019) confirm this finding by Lou and Shou (2017) and further mention that the performance of Amihud’s measure drop significantly out-of-sample. Florackis et al. (2011) propose alternative price impact measure based on turnover. Finally, Amihud (2019) comments on the performance of his price impact measure and builds a pricing factor based on it.

2. I thank Lubos Pastor and Ronnie Sadka for making their liquidity factors available on their websites, respectively: http://faculty.chicagobooth.edu/lubos.pastor/research/liq_data_1962_2010.txt, and http://www2.bc.edu/~sadka/Sadka-LIQ-factors-1983-2010-WRDS.xlsx.

3. Sadka (2006) constructs four liquidity factors but argues that out of them; only the permanent-variable factor is priced. I continue to use the same factor for consistency.

Additional information

Funding

The author would like to acknowledge funding by the Caisse de dépôt et placement du Québec (CDPQ) research chair.