The Relationship Between Liquidity, Variability Of Liquidity And Stock Returns In China

Like the other financial assets, liquidity can affect stock returnslargely, for any financial assets need to rely on liquid markets to realize returns.The relationship between liquidity and stock returns has been a hot topic in thetheoretical research on the capital market. In this paper, I want to bring newthoughts of the research on the pricing of liquidity and the variability in Chinaand add new empirical evidences.The discussion of the relationship between liquidity and stock returnsstarted from mid 1980s. The majority hold that if the investors are rational, tomaintain the overall wealth, the market has to give higher returns for lowerliquidity. Most empirical evidences also support this view. However, in China,the stock market is speculative and the transaction is frequent. So in such amarket, what is the relationship between liquidity and stock returns is ameaningful question.Liquidity is an extensive notion, and difficult to be defined, so it isnecessary to find out what liquidity is and how to measure it. At present, ageneral definition for liquidity is: the ability to sell or buy large number ofsecurities with low transaction cost, reasonable price and small affects on themarket price. To further state the essential of liquidity I also introduce the fourdimensions of liquidity, which are immediacy, width, depth and resiliency.According to the frequency of usage, in this paper I mainly introduce pricemethod and trading-volume method to measure liquidity.In addition, the liquidity rule is the most important rule of the tradingmechanism, so the trading mechanism will affect liquidity significantly. Inchapter three, I analyze liquidity under the present trading mechanism ofChina. In the Chinese stock market, the stock exchanges use order-drivensystem. Under this system, the characteristic of liquidity is to providetransparency. In this section, I also make analysis of the affects of the smallestbid unit, limitation on price variability and large trading on liquidity.In chapter four, I investigate the theoretical and empirical relationsbetween liquidity, the variability of liquidity and stock returns. Since Amuind(1986), the theoretical research on liquidity and stock returns can be summedas two conclusions: (1) less liquid stocks will be allocated in long-terminvestment portfolios. (2) In equilibrium, stock returns are the decreasingfunction of liquidity. This means in theory, the liquidity of stock is low whenthe trading cost is high, and the investors have to get more returns to offset theilliquidity. The theoretical research on the relationship between variability ofliquidity and stock returns is a blank. In this paper, I make an initial attempttowards this direction. The framework will first develop a model representingthe linear relationship between the liquidity risk and the asset returns, in thismodel, the liquidity risk acts as part of beta. Then from the existed assetpricing theory, we know the changing risk of the discount factor can predictthe asset returns, furthermore the discount factor and beta have intimaterelations, so the relationship between the variability of liquidity and assetreturns can be established. Following this thought,I reach this conclusion thatthere exists negative relationship between the variatbility of liquidity and stockreturns.In the real world, investor will face indefinite investing-term restrictionand strict borrowing restriction, which makes the premium of liquidity oftenexceeds the prediction of theoretical model. In this paper, after the theoreticalanalysis, I also make empirical tests using the monthly trading data of 100stocks listed on Shanghai Exchange from 2000 to 2005. Chinese stock marketemploys continuous order-driven trading mechanism. To get long-term testingresults, and also considering the difficulties, I choose the trading volume andturnover rate as proxies of liquidity risk and the standard deviation of the past12-month liquidity risk as the proxies of the variability of liquidity for eachmonth. For each stock, I calculate the natural logarithm of every variable andmake correlation analysis, substratification analysis and regression analysis. Inthe regressions, I regress the excess returns on size of stocks, the ratio of priceand net book value, the proxies of liquidity risks, and the proxies of thevariability of liquidity. The correlation analysis suggests that for turnover rate,the excess asset returns have position relationship with turnover rate andnegative relationship with the standard variation of turnover rate. For tradingvolume, the asset returns have position relationship with both trading volumeand the standard variation of trading volume. The substratification analysissuggests that asset returns show both increasing trends when trading volumeand turn over rate increase. In the portfolios based on the standard variation oftrading volume substratification, asset returns show decreasing trend, but forthe standard variation of turnover rate, there is no an obvious trend. Finally,the regression analysis reaches the conclusions that for trading volume, thecoefficient of trading volume is positive and significant, while the standardvariation of trading volume is negative. For turnover rate, I get the sameconclusion. So according to the testing results, in the Chinese stock market,the increase of liquidity will demand higher returns, and the increase of thevariation of liquidity will have opposite affects.In the following, I explain the two conclusions. For the conclusion ofliquidity means that more liquid stock will demand higher returns, which is incontrast to the normal law, so I mainly explain why this happens in theChinese market. I hold that this result can't prove that the liquidity effect iswrong, it just reflects that the liquidity effect can't be applied to the Chinesemarket. The basic reason is the dividing -shares system. In the first market, itmakes new issues be traded frequently and priced highly. In the second market,it makes the stocks be easily bid up. As a result, in the Chinese stock market,liquidity has different affects from the developed markets. Such distortedpricing system will not help the development of the stock market, and theoriginal reason is the dividing-share system, so in this paper, I also givesuggestions to resolve this problem. To settle the problem smoothly, we haveto establish ownership restriction, give the listed corporations more freedom,and protect the benefits of the former liquid shareholders.