Working Paper: CEPR ID: DP5946
Authors: Geert Bekaert; Campbell Harvey; Christian T. Lundblad
Abstract: Given the cross-sectional and temporal variation in their liquidity, emerging equity markets provide an ideal setting to examine the impact of liquidity on expected returns. Our main liquidity measure is a transformation of the proportion of zero daily firm returns, averaged over the month. We find that our liquidity measures significantly predict future returns, whereas alternative measures such as turnover do not. Consistent with liquidity being a priced factor, unexpected liquidity shocks are positively correlated with contemporaneous return shocks and negatively correlated with shocks to the dividend yield. We consider a simple asset pricing model with liquidity and the market portfolio as risk factors and transaction costs that are proportional to liquidity. The model differentiates between integrated and segmented countries and time periods. Our results suggest that local market liquidity is an important driver of expected returns in emerging markets, and that the liberalization process has not fully eliminated its impact.
Keywords: emerging markets; liquidity; pricing; return predictability
JEL Codes: F3; G3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| liquidity measures (E41) | future returns (G17) |
| unexpected liquidity shocks (F65) | return shocks (E32) |
| unexpected liquidity shocks (F65) | shocks to the dividend yield (G35) |
| local market liquidity (G10) | expected returns (G17) |
| market liberalization (G18) | impact of liquidity on expected returns (G12) |
| liquidity risk (G33) | expected returns (G17) |