Flight-to-liquidity: Evidence from China's stock market

In an order-driven and strictly regulated stock market, illiquidity risks' effects on asset pricing should be highlighted, particularly in such extreme market conditions as those in China. This paper utilizes panel data from China's stock market in an attempt to answer whether the illiquidity risk in various dimensions—including price impacts, the transaction speed, trading volume, transaction costs, and asymmetric information—can explain stock returns. We find that almost all dimensions of stock illiquidity are positively associated with excess stock returns. More importantly, smaller, less-liquid stocks suffer more liquidity costs, providing a strong evidence for “flight-to-liquidity.” Additionally, the transaction costs and asymmetric information, denoted by bid-ask spreads, robustly account for these illiquidity effects on stock pricing and differ from the findings in the U.S. market. We also find that the “flight-to-liquidity” can partially explain the idiosyncratic volatility puzzle, investors' gambling, and herding psychologies. This study provides substantial policy implications in regulation and portfolio management for emerging markets.