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Does liquidity drive stock market returns? The role of investor risk aversion

Does liquidity drive stock market returns? The role of investor risk aversion
Does liquidity drive stock market returns? The role of investor risk aversion
In this paper, we explore the relations between liquidity, stock returns, and investor risk aversion as captured by the variance risk premium (VRP). This is motivated by theoretical and empirical evidence in the literature which suggests that investor risk aversion negatively correlates with asset liquidity, and ample empirical evidence documenting liquidity risk premium. We use monthly US data from January 1999 to December 2018 and show that innovations in the VRP Granger-cause stock returns, which in turn drive liquidity. Our findings are consistent with predictions of prior theories and highlight the predictability of the VRP. They also contribute to the on-going debate on the causal relation between stock returns and liquidity. Finally, we explore the channels through which the VRP impacts liquidity and find that the VRP influences market and momentum factors, and that movements in these factors lead to changes in liquidity.
Systematic factors, Toda-Yamamoto Granger non-causality test
0924-865X
Zhang, Qingjing
af719b43-b76c-4d0e-ad41-ff58ebbc505d
Choudhry, Taufiq
6fc3ceb8-8103-4017-b3b5-2d38efa57728
Kuo, Jing-Ming
871aa9bc-3179-48f9-9bf6-2fd36f6beb0a
Liu, Xiaoquan
bd759207-171e-45e1-ad9c-7b850e80ce2c
Zhang, Qingjing
af719b43-b76c-4d0e-ad41-ff58ebbc505d
Choudhry, Taufiq
6fc3ceb8-8103-4017-b3b5-2d38efa57728
Kuo, Jing-Ming
871aa9bc-3179-48f9-9bf6-2fd36f6beb0a
Liu, Xiaoquan
bd759207-171e-45e1-ad9c-7b850e80ce2c

Zhang, Qingjing, Choudhry, Taufiq, Kuo, Jing-Ming and Liu, Xiaoquan (2021) Does liquidity drive stock market returns? The role of investor risk aversion. Review of Quantitative Finance and Accounting. (In Press)

Record type: Article

Abstract

In this paper, we explore the relations between liquidity, stock returns, and investor risk aversion as captured by the variance risk premium (VRP). This is motivated by theoretical and empirical evidence in the literature which suggests that investor risk aversion negatively correlates with asset liquidity, and ample empirical evidence documenting liquidity risk premium. We use monthly US data from January 1999 to December 2018 and show that innovations in the VRP Granger-cause stock returns, which in turn drive liquidity. Our findings are consistent with predictions of prior theories and highlight the predictability of the VRP. They also contribute to the on-going debate on the causal relation between stock returns and liquidity. Finally, we explore the channels through which the VRP impacts liquidity and find that the VRP influences market and momentum factors, and that movements in these factors lead to changes in liquidity.

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Does liquidity drive stock market returns_The role of the variance risk premium - Accepted Manuscript
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More information

Accepted/In Press date: 17 February 2021
Keywords: Systematic factors, Toda-Yamamoto Granger non-causality test

Identifiers

Local EPrints ID: 447324
URI: http://eprints.soton.ac.uk/id/eprint/447324
ISSN: 0924-865X
PURE UUID: 4e74e328-a9ba-4ac0-8ae2-2f71e5ea83ac
ORCID for Taufiq Choudhry: ORCID iD orcid.org/0000-0002-0463-0662

Catalogue record

Date deposited: 09 Mar 2021 17:32
Last modified: 27 Mar 2021 02:38

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Contributors

Author: Qingjing Zhang
Author: Taufiq Choudhry ORCID iD
Author: Jing-Ming Kuo
Author: Xiaoquan Liu

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