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Stock Returns and the Volatility of Liquidity

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  • Pereira, João Pedro
  • Zhang, Harold H.

Abstract

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.

Suggested Citation

  • Pereira, João Pedro & Zhang, Harold H., 2010. "Stock Returns and the Volatility of Liquidity," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 45(04), pages 1077-1110, August.
  • Handle: RePEc:cup:jfinqa:v:45:y:2010:i:04:p:1077-1110_00
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    References listed on IDEAS

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    Cited by:

    1. Galariotis, Emilios & Giouvris, Evangelos, 2015. "On the stock market liquidity and the business cycle: A multi country approach," International Review of Financial Analysis, Elsevier, vol. 38(C), pages 44-69.
    2. Turan G. Bali & Lin Peng & Yannan Shen & Yi Tang, 2013. "Liquidity Shocks and Stock Market Reactions," Koç University-TUSIAD Economic Research Forum Working Papers 1304, Koc University-TUSIAD Economic Research Forum.
    3. Benjamin M. Blau & Ryan J. Whitby, 2015. "The Volatility of Bid-Ask Spreads," Financial Management, Financial Management Association International, vol. 44(4), pages 851-874, October.
    4. Barinov, Alexander, 2015. "Why does higher variability of trading activity predict lower expected returns?," Journal of Banking & Finance, Elsevier, vol. 58(C), pages 457-470.
    5. repec:eee:intfin:v:51:y:2017:i:c:p:15-38 is not listed on IDEAS
    6. Isaenko, Sergei, 2010. "Portfolio choice under transitory price impact," Journal of Economic Dynamics and Control, Elsevier, vol. 34(11), pages 2375-2389, November.
    7. repec:bla:jfnres:v:40:y:2017:i:1:p:113-140 is not listed on IDEAS

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