The influence of economic policy uncertainty on stock market liquidity? The mediating role of investor sentiment

Abstract

Purpose

The study examines the relationship between Economic Policy Uncertainty (EPU) and stock liquidity, and the mediating role of investor sentiment.

Design/methodology/approach

This study draws on a sample of 4,620 firm-year observations covering nonfinancial firms in the United States from 2007 to 2020. We employ multiple regression analysis with panel data and path analysis with Structural Equation Modeling (SEM) to examine the impact of EPU on stock liquidity in detail.

Findings

EPU significantly enhances stock liquidity. However, at elevated levels of EPU, this relationship reverses. The path analysis results indicate that EPU positively affects stock liquidity via the investor sentiment channel. This sentiment partially mediates the relationship between EPU and both trading volume and turnover rate, and fully mediates the relationship between EPU and both turnover price impact and illiquidity.

Practical implications

Our findings underscore the importance of liquidity for investors, who may require higher returns for holding more illiquid stocks. Second, they can help the government understand the implications of changes in EPU, highlighting the need for clear communication and the implementation of appropriate capital market policies.

Originality/value

While considerable research focuses on the relationship between EPU and stock market liquidity, the analysis of the channels through which EPU influences stock market liquidity remains largely unexplored. Our study highlights the importance of investor sentiment in explaining this relationship.

Citation

Nasraoui, M., Ajina, A. and Kahloul, A. (2024), "The influence of economic policy uncertainty on stock market liquidity? The mediating role of investor sentiment", Journal of Risk Finance, Vol. 25 No. 4, pp. 664-683. https://doi.org/10.1108/JRF-06-2023-0129