Liquidity and stock returns: Evidence from international markets

Abstract

This paper tests the relation between expected excess stock returns and illiquidity risk in G7 markets. By conducting panel regressions on monthly data for 20 years, evidence shows that excess stock returns of the G7 countries are positively correlated with market illiquidity risk, but are negatively correlated with the innovation of firm-level illiquidity. Applying the model to the portfolio analysis, the evidence shows that the market-level illiquidity risk has a more profound effect on excess stock returns for large stocks, growth stocks, more liquid stocks, lower idiosyncratic risk stocks, and lower skewness stocks. However, the innovation from firm-level illiquidity has a stronger effect on small stocks, value stocks, more illiquid stocks, higher idiosyncratic risk stocks, lower skewness stocks, and lower kurtosis stocks.