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Liquidity Shocks and Stock Market Reactions

Author

Listed:
  • Turan G. Bali
  • Lin Peng
  • Yannan Shen
  • Yi Tang

Abstract

We find that the stock market underreacts to stock-level liquidity shocks: liquidity shocks are not only positively associated with contemporaneous returns, but they also predict future return continuations for up to six months. Long-short portfolios sorted on liquidity shocks generate significant returns of 0.70% to 1.20% per month that are robust across alternative shock measures and after controlling for risk factors and stock characteristics. Furthermore, we show that investor inattention and illiquidity contribute to the underreaction: while both are significant in explaining short-term return predictability of liquidity shocks, the inattention-based mechanism is more powerful for the longer-term return predictability.

Suggested Citation

  • Turan G. Bali & Lin Peng & Yannan Shen & Yi Tang, 2014. "Liquidity Shocks and Stock Market Reactions," The Review of Financial Studies, Society for Financial Studies, vol. 27(5), pages 1434-1485.
    • Handle: RePEc:oup:rfinst:v:27:y:2014:i:5:p:1434-1485.
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    File URL: http://hdl.handle.net/10.1093/rfs/hht074
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