An Empirical Exploration Of Liquidity And Expected Returns On Chinese Stock Markets Based On Turnover Ratios

Liquidity, which enables investors to buy or sell some amount of assets quickly at less transaction costs, is one of most important attributes of assets. Maintaining adequate liquidity is a key condition for the existence and development of security markets. The liquidity-expected return relationship is a hot area in the theoretical and empirical research on liquidity. Based on Amihud and Mendelson's (1986), and Amihud's (2002), this paper performs an empirical exploration of liquidity and expected returns on Chinese stock markets using the turnover ratio as a proxy for liquidity. By cross-sectional regressions, the evidence shows that liquidity premiums exist in Chinese stock markets - assets with higher turnover rates, lower transactions costs and hence higher liquidity have lower expected returns. The effect persists after controlling for the well-known determinants of stock return like firm-size, book-to-market ratio and return-to-price ratio. Unlike Eleswarapu and Reinganum's(1993), this paper finds that the liquidity premium effect is not restricted to the month of January alone and is prevalent and stable during the whole sample period. We also test the trading frequency null hypothesis against the transaction cost hypothesis and the result confirms that the asset expected return is a decreasing and convex function of turnover rates, suggesting that cross-sectional variation in transaction costs is the root cause for liquidity premiums. In addition, time-series explorations have been performed. Different from developed markets, we find that over time, expected and unexpected market liquidity positively affect on stock excess return, which leads to that more liquid stocks experience stronger effects of market liquidity after substitution from less liquid to more liquid stocks. Finally, we suppose that the under-developed market situation and excessive speculative behaviors might to some degree, contribute to the abnormal liquidity-expected return relationship on Chinese stock markets.