Liquidity Premium And Liquidity Pricing: Evidence From China

Liquidity is one of the key indicators to measure how well the financial market is functioning. In essence the main duties of financial regulators and market makers are to ensure a liquid market.Therefore, researchers have proposed a number of liquidity measuers to study the relationship between liquidity and expected returns of assets. Since early 2002, Amihud proposed a theory of liquidity premium. That is, low-liquidity stocks shows higher returns, on average, than high-liquidity stocks. Then, researchers have explored the systematic nature of liquidity and found that liquidity risk is important for asset pricing. Following the 2007 liquidity crisis, liquidity research has become a more pressing need. China stock markets are important to the international emerged markets. Based on the multidimensionality of liquidity, this paper uses turnover, return-to-volume, trading amount to explore whether liquidity risk can price assets in China stock markets.The sample comprises all Shanghai/Shenzhen ordinary common stocks over the period January 1990 to December 2012. This study has three issues: (1) Analysis of liquidity premium. Firstly, the cross-sectional regression results which is that return-to-volume and trading amount can predict stock returns significantly, it is in line with the theory of liquidity premium. Secondly, we begin our empirical tests with portfolios sorted, by the three liquidity measures:turnover, return-to-volume, trading amount. We form portfolios each month and classify them into decile. We have found that the three liquidity proxies based on B-S premium are all not equel to zero significantly at 0.01 level, indicating that there is a significant liquidity premium in China stock markets. (2) Analysis after risk adjustment. To adjust for risk in China stock markets, we rely on the CAPM and the FF3FM which are commonly used in literature. Overall, the premium associated with the three liquidity proxie(turnover, return-to-volume, trading amount) are not robust to the CAPM or the FF3FM adjustment. Therefore, RM, SMB, HML do not show significant return predictability. Then we do a further analysis after adjusting for liquidity risk. (3) To ascertain whether liquidity risk can predict stock returns, we based on Liu’s idea(2006) to construct the new LCAPM. The results that the LCAPM performs better than either the CAPM or FF3M, and it accounts for premiums related to the three liquidity proxies examined wih China stock markets. It is comfirmed that liquidity risk is a pricing factor.The innovation of this paper is the research of LCAPM which is an useful complement to the research of asset pricing theory. Our study helps practitioners and academic researchers to select an adequate liquidity measure and an asset pricing model to use, but it also offers a reference.when investors explore the relationship between liquidity and expected returns to make right investment decisions.