DP3494 Liquidity Risk and Expected Stock Returns

Author(s): Lubos Pástor , Robert F Stambaugh

Publication Date: August 2002

Keyword(s): asset pricing , liquidity risk , expected returns

JEL(s): G12

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP3494.asp

This study investigates whether market-wide liquidity is a state variable important for asset pricing. We find that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Our monthly liquidity measure, an average of individual-stock measures estimated with daily data, relies on the principle that order flow induces greater return reversals when liquidity is lower. Over a 34-year period, the average return on stocks with high sensitivities to liquidity exceeds that for stocks with low sensitivities by 7.5% annually, adjusted for exposures to the market return as well as size, value, and momentum factors.