The Effect Of Liquidity Shock On Stock Returns

The liquidity of a stock refers to the degree to which a significant quantity canbe traded within a short time frame without incurring a large transaction costor adverse price impact. Amihud and Mendelson (1986) were the first to arguethat investors demand a premium for less liquid stocks, so that less liquid stocksshould have higher average returns. Subsequently, it is well documented thatthe level of individual stock illiquidity is positively priced in the cross-sectionof expected stock returns.Liquidity is also time-varying, and subject to shocks that have persistenteffects (that is, negative liquidity shocks predict lower future liquidity). Themost recent financial crisis and the heightened focus on liquidity during thecrisis show the importance of considering the effect of liquidity shocks on stockreturns. Given the positive relation between stock-level illiquidity and expectedreturns, a persistent negative shock to a security's liquidity should, as pointedout by Acharya and Pedersen (2005), result in low contemporaneous returnsand high future returns, and vice versa. However, this prediction of a negativerelation between liquidity shocks and future returns may not hold in a marketin which information is not fully reflected into prices due to market frictions.Thus, studying market reactions to liquidity shocks can generate importantinsights on how the market processes information about liquidity shocks andon the information efficiency of financial markets.This paper focuses on liquidity shocks, which can be viewed as a type ofpublic information on liquidity. Compared with the direct and well definedinformation events studied in the previous literature, liquidity shocks are notwell defined and their pricing implications are harder to interpret by averageinvestors. As argued by Hirshleifer, Hsu, and Li (2013), investors would "havegreater difficulty processing information that is less tangible"; the indirect andellusive nature of liquidity news thus makes the investors' attention constraintsmore likely to be binding. As a result, the stock market can underreact toliquidity shocks. Moreover, as indicated in the model of Peng and Xiong(2006), an investor who optimizes the amount of attention allocation wouldallocate more attention to systematic shocks and less to stock-specific shocks(in some cases even completely ignoring them). Thus, a strong case can be madefor underreaction to stock-level liquidity shocks based on theories of investorattention. Alternatively, when a stock is harder to trade due to its illiquidity,price discovery can be delayed, resulting in slow price adjustments followingliquidity shocks.To investigate how the stock market reacts to stock-level liquidity shocks,we first examine the immediate effect of liquidity shocks and find that it ispositive and significantly related to contemporaneous stock returns. However,in terms of the relation between liquidity shocks and future returns, contraryto the negative relation as one would expect in a full, informationally efficientsetting, we find the relation continues to be positive and highly significant.This evidence suggests that the market underreacts to stock-level liquidityshocks. Although negative and persistent liquidity shocks do result in decreasesin stock prices due to a higher future risk premium, the price adjustment is notcomplete within the same month. As a result, there is a considerable amountof continuation of negative returns, and the effects of shocks are not fullyincorporated into prices until months later. The opposite is true for positiveliquidity shocks.