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Cross-sectional Variation in Stock Returns: Liquidity and Idiosyncratic Risk

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  • Matthew Spiegel
  • Xiaotong Wang
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    Abstract

    The roles played by idiosyncratic risk and liquidity in determining stock returns have recently received a great deal of attention. However, recent empirical tests have not examined the interaction between these two factors. As others have shown (and this paper confirms) stocks idiosyncratic risk and liquidity are negatively correlated. To what extent then is each variable responsible for the observed cross sectional patterns in stock returns? Overall, using monthly data, the paper finds that stock returns are increasing with the level of idiosyncratic risk and decreasing in a stock's liquidity. However, while both liquidity and idiosyncratic risk play a role in determining returns, the impact of idiosyncratic risk is much stronger and often eliminates liquidity's explanatory power. The point estimates indicate that a one standard deviation change in idiosyncratic risk has between 2.5 and 8 times the impact of a corresponding change in liquidity on cross sectional expected returns.

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    File URL: http://icfpub.som.yale.edu/publications/2540
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    Bibliographic Info

    Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number amz2540.

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    Date of creation: 01 Apr 2005
    Date of revision: 01 Mar 2006
    Handle: RePEc:ysm:somwrk:amz2540

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    Web page: http://icf.som.yale.edu/
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    Keywords: idiosyncratic risk; liquidity; stock returns;

    References

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    1. Amihud, Yakov, 2002. "Illiquidity and stock returns: cross-section and time-series effects," Journal of Financial Markets, Elsevier, vol. 5(1), pages 31-56, January.
    2. Pastor, Lubos & Stambaugh, Robert F., 2003. "Liquidity Risk and Expected Stock Returns," Journal of Political Economy, University of Chicago Press, vol. 111(3), pages 642-685, June.
    3. Dimitri Vayanos, 1998. "Transaction costs and asset prices : a dynamic equilibrium model," LSE Research Online Documents on Economics 451, London School of Economics and Political Science, LSE Library.
    4. Stoll, Hans R, 1978. "The Pricing of Security Dealer Services: An Empirical Study of NASDAQ Stocks," Journal of Finance, American Finance Association, vol. 33(4), pages 1153-72, September.
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    6. Brennan, Michael J. & Subrahmanyam, Avanidhar, 1996. "Market microstructure and asset pricing: On the compensation for illiquidity in stock returns," Journal of Financial Economics, Elsevier, vol. 41(3), pages 441-464, July.
    7. Nelson, Daniel B, 1991. "Conditional Heteroskedasticity in Asset Returns: A New Approach," Econometrica, Econometric Society, vol. 59(2), pages 347-70, March.
    8. Viral V. Acharya & Lasse Heje Pedersen, 2004. "Asset Pricing with Liquidity Risk," NBER Working Papers 10814, National Bureau of Economic Research, Inc.
    9. Maureen O'Hara, 2003. "Presidential Address: Liquidity and Price Discovery," Journal of Finance, American Finance Association, vol. 58(4), pages 1335-1354, 08.
    10. Easley, David & Kiefer, Nicholas M & O'Hara, Maureen, 1997. "One Day in the Life of a Very Common Stock," Review of Financial Studies, Society for Financial Studies, vol. 10(3), pages 805-35.
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    12. Amit Goyal & Pedro Santa-Clara, 2003. "Idiosyncratic Risk Matters!," Journal of Finance, American Finance Association, vol. 58(3), pages 975-1008, 06.
    13. Eric Ghysels & Pedro Santa-Clara & Rossen Valkanov, 2004. "There is a Risk-Return Tradeoff After All," NBER Working Papers 10913, National Bureau of Economic Research, Inc.
    14. Turan G. Bali & Nusret Cakici & Xuemin (Sterling) Yan & Zhe Zhang, 2005. "Does Idiosyncratic Risk Really Matter?," Journal of Finance, American Finance Association, vol. 60(2), pages 905-929, 04.
    15. Merton, Robert C, 1987. " A Simple Model of Capital Market Equilibrium with Incomplete Information," Journal of Finance, American Finance Association, vol. 42(3), pages 483-510, July.
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    17. Malcolm Baker & Jeremy C. Stein, 2002. "Market Liquidity as a Sentiment Indicator," NBER Working Papers 8816, National Bureau of Economic Research, Inc.
    18. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
    19. Spiegel, Matthew & Subrahmanyam, Avanidhar, 1995. " On Intraday Risk Premia," Journal of Finance, American Finance Association, vol. 50(1), pages 319-39, March.
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    Cited by:
    1. Doran, James & Jiang, Danling & Peterson, David, 2007. "Short-Sale Constraints and the Non-January Idiosyncratic Volatility Puzzle," MPRA Paper 4995, University Library of Munich, Germany.
    2. Duan, Ying & Hu, Gang & McLean, R. David, 2010. "Costly arbitrage and idiosyncratic risk: Evidence from short sellers," Journal of Financial Intermediation, Elsevier, vol. 19(4), pages 564-579, October.
    3. Fu, Fangjian, 2009. "Idiosyncratic risk and the cross-section of expected stock returns," Journal of Financial Economics, Elsevier, vol. 91(1), pages 24-37, January.
    4. Wagner, Niklas & Winter, Elisabeth, 2013. "A new family of equity style indices and mutual fund performance: Do liquidity and idiosyncratic risk matter?," Journal of Empirical Finance, Elsevier, vol. 21(C), pages 69-85.
    5. Bley, Jorg & Saad, Mohsen, 2012. "Idiosyncratic risk and expected returns in frontier markets: Evidence from GCC," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 22(3), pages 538-554.
    6. Chabi-Yo, Fousseni, 2011. "Explaining the idiosyncratic volatility puzzle using Stochastic Discount Factors," Journal of Banking & Finance, Elsevier, vol. 35(8), pages 1971-1983, August.
    7. Doran, James & Jiang, Danling & Peterson, David, 2008. "Gambling Preference and the New Year Effect of Assets with Lottery Features," MPRA Paper 15463, University Library of Munich, Germany, revised 10 Mar 2009.
    8. Au, Andrea S. & Doukas, John A. & Onayev, Zhan, 2009. "Daily short interest, idiosyncratic risk, and stock returns," Journal of Financial Markets, Elsevier, vol. 12(2), pages 290-316, May.

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