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Stock Returns and the Volatility of Liquidity

  • Pereira, João Pedro
  • Zhang, Harold H.

This paper offers a rational explanation for the puzzling empirical fact that stock returns decrease with an increase in the volatility of liquidity. We model liquidity as a stochastic price impact process and define the liquidity premium as the additional return necessary to compensate a multiperiod investor for the adverse price impact of trading. The model demonstrates that a fully rational, utility maximizing, risk-averse investor can take advantage of time-varying liquidity by adapting his trades to the state of liquidity. We provide new empirical evidence supportive of the model.

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Article provided by Cambridge University Press in its journal Journal of Financial and Quantitative Analysis.

Volume (Year): 45 (2010)
Issue (Month): 04 (August)
Pages: 1077-1110

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Handle: RePEc:cup:jfinqa:v:45:y:2010:i:04:p:1077-1110_00
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