Reexamination of stock liquidity risk with a relative measure

Abstract

Purpose

Negative relationship between the return of a stock and its liquidity suggests that the illiquid stocks are riskier than liquid stocks. Thus, researchers tend to include the stock liquidity as a variable in asset pricing models, where the stock and market liquidities are usually considered as independent. The purpose of this paper is to reexamine the relationship between the return of a stock and its liquidity by using a relative measure that links the individual stock liquidity with market‐wide liquidity.

Design/methodology/approach

Multivariate regressions are employed to examine the effect of relative market liquidity on the stock return while controlling the effects of other factors.

Findings

Negative relationship between the stock return and liquidity is confirmed, but the relationship is not linear. It is found that the relative measure of liquidity is not a substitute, but complement to other liquidity measures used in prior studies. It is also found that fluctuation in relative stock liquidity does not positively affect the return.

Research limitations/implications

The study is conducted on New York Stock Exchange and American Stock Exchange exchanges using monthly data. The robustness tests using the daily or weekly data are not conducted.

Practical implications

Findings may suggest that investors do not seriously concern about the fluctuations of individual stock liquidity, provided that the stock liquidity is higher than the average market liquidity.

Originality/value

For the first time, the liquidity risk is tested using a relative measure instead of an absolute measure. Since fluctuation in stock liquidity does not positively affect the return, a new question arises whether the variability in liquidity can reflect the liquidity risk.

Citation

Uddin, H. (2009), "Reexamination of stock liquidity risk with a relative measure", Studies in Economics and Finance, Vol. 26 No. 1, pp. 24-35. https://doi.org/10.1108/10867370910946306