Research On The Liquidity Premium In Chinese Stock Market

A fundamental assumption underlying the traditional financial market theory isthat the price formation occurs in an environment without friction. In reality, however,investors face liquidity constraints in virtually all financial markets. The extent towhich liquidity affects security prices has itself become a controversial issue in assetpricing.As an emerging market, Chinese stock market is thought of a thinner market. Tobetter understand the role that liquidity plays in security valuation in Chinese stockmarket, this paper engages a comprehensive research about the liquidity premium inChinese stock market, focusing on the premium mode and its qualification. The maincontent includes:1. As little research can be found in this field in China, it deals with the dynamicrelationship between liquidity and return in Chinese stock market. It is found that thecharacter of liquidity changes with the development of Chinese stock market, and alsofound is the empirical evidence consistent with the notion of "illiquidity premium" in2002, using such econometric methods as VAR model, Granger causality test etc. Theresult show that liquidity risk can not be neglected in Chinese stock market, it needspremium.2. To explain the phenomena of "illiquidity premium" in Shanghai stock marketin 2002, it established a GARCH-M model after liquidity adjustment for the returnand risk series and two hypotheses about the illiquidity premium. Empirical evidenceshowed that the hypotheses are reasonable, i.e. expected market illiquidity positivelyaffects ex ante stock excess return, suggesting that expected stock excess return partlyrepresents an illiquidity premium, also, stock return are negatively related tocontemporaneous unexpected illiquidity.3. It studies the extremal dependence of market and liquidity risk in Shanghaistock market, the former being measured through the market return and the latterbeing measured through the width, using tools from Extreme Value Theory for the firsttime in this research field. It found some evidence of a) asymmetric behavior in theleft and right tails of the joint marginal extreme distribution, and b) correlationincreases in bear markets, but not in bull markets.4. An option-theoretical approach can be used to value illiquidity securitydiscount. That is, a look-back option can be used to describe a simple analytical upperbound on the cost of illiquidity. This analysis provides a benchmark for assessing thepotential costs from non-marketability and thinly-traded market. Also, it is a usefultool to valuate the illiquidity premium.5. Close-end fund discount phenomena in china can not be well explained by allthe theory in existence. It is a doubt that if illiquidity is an important reason, becausethere is no right technique to test the view. Using option-theoretical approach to valueilliquidity security discount, it took an empirical study about the close-end funddiscount for example. That is, a look-back option can be used to describe a simpleanalytical upper bound on the cost of illiquidity. It is found that illiquidity is not animportant reason to explain CEF discount in Chinese stock market.6. It proposes a practical framework for the quantification of liquidity premium,by designing an optimal liquidation strategy. In a thin market, considering the marketimpact caused by the investors' own dealings, a rational investor liquidates hisposition by steps to maximize his utility. According to the no-arbitrage principle, thepremium can be calculated. It is found that it decreases with the increasing of theinvestment horizon, but the premium keep persistent while continuing increase thehorizon.The research has its important signification: first, it can be a base for further assetvaluation research to relax its original traditional assumptions;second, it can providesome useful information for governor and investors.However, the study is still developed under a traditional framework. A morechallenge work is to research under financial microstructure environment, focusing onhuman behavior and dealing system.