The role of liquidity in asset pricing: the special case of the Portuguese Stock Market.
| Autor | del Mar Miralles-Quiros, Maria |
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Introduction
In recent years, a large part of financial research has been devoted to the study of equity market liquidity. Initial studies focused on the liquidity of individual assets and its impact on returns (Amihud and Mendelson, 1986; Brennan and Subrahmanyam, 1996; Datar et al., 1998; Eleswarapu and Reinganum, 1993). However, recent studies have been based on the analysis of commonality in liquidity (Chordia et al., 2000; Hasbrouck and Seppi, 2001; Huberman and Halka, 2001) and demonstrate that individual liquidity co-moves with aggregate or systematic liquidity. Consequently, another strand of liquidity-related studies has emerged, which focuses on the link between asset returns and liquidity risk (Amihud, 2002; Pastor and Stambaugh, 2003) Acharya and Pedersen (2005). However, these previous studies have focused on the analysis of the US stock market and the evidence for tiny markets as the Portuguese one is limited.
The aim of our study is to analyse the role of liquidity in asset pricing in a tiny market as the Portuguese one. The contribution of our study is two-fold. First, we improve international empirical evidence with an in-depth analysis of the Portuguese stock market over the period 1988-2013. The unique setting of the Lisbon Stock Exchange with regards to changes in classification from an emerging to a developed stock market over the sample period, allows for an original answer to whether changes in the development of the market affect the role of liquidity in asset pricing. Moreover, gathering evidence from other data sets is important to check the robustness of the available results and to avoid the problem of data snooping (Lo and MacKinlay, 1990), as the majority of the empirical results previously reported use of US data. In addition, it is acknowledged that liquidity effects are more pronounced for illiquid assets and markets. So, studying markets that are sufficiently illiquid may allow for a better understanding of the pervasiveness of these effects. In the current study, such a goal is best achieved by selecting the Portuguese stock market in which illiquidity is likely to be an important factor for many of its listed stocks.
Second, we propose and compare two alternative implications of liquidity in asset pricing. More precisely, we adapt the liquidity-adjusted capital asset pricing model (CAPM) proposed by Acharya and Pedersen (2005) for the Portuguese case and suggest two alternative specifications of a liquidity-adjusted CAPM, to separate and compare the effects of liquidity and liquidity risk in asset pricing. Moreover, we use the proportion of zero returns proposed by Lesmond et al. (1999), which is an appropriated measure of liquidity in tiny markets such. However, before drawing some overall conclusions, we also evaluate the money-augmented CAPM proposed by Balvers and Huang (2009), which is characterised by adding a risk premium for money growth which can be interpreted as an economy's liquidity premium. To our knowledge, this is the first study that provides evidence of the M-CAPM for a small and tiny market as the Portuguese one.
Our initial results show that individual illiquidity affects Portuguese stock returns. However, in contrast to previous evidence from other markets, they show that the most traded stocks (hence the most liquid stocks) exhibit larger returns. In addition, we show that the illiquidity effects on stock returns were higher and more significant in the period from January 1988 to November 1997, during which the Portuguese stock market was still an emerging market. Similar results are provided when the M-CAPM is tested. These findings are relevant for investors when they make their investment decisions and for market regulators because they reflect the need for improving the competitiveness of the Portuguese stock market. Additionally, these findings are a challenge for academics because they exhibit the need for providing alternative theories for tiny markets such as the Portuguese one.
The remainder of the paper is organised as follows: Section 2 presents the literature review. Section 3 describes the data, the liquidity measure and the portfolio formation procedure. The methodology and results of the asset pricing tests are presented and discussed in Section 4. Finally, Section 5 concludes the paper.
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Previous empirical evidence
Studies about liquidity primarily concentrated on analysing the impact of individual assets liquidity on returns (Amihud and Mendelson, 1986; Brennan and Subrahmanyam, 1996; Datar et al., 1998; Eleswarapu and Reinganum, 1993). However, the evidence reported is ambiguous: some authors find a positive relation between asset returns and illiquidity, but others only find such a positive relation in January. The work of Amihud and Mendelson (1986) was one of the first to examine the role of liquidity in asset pricing using the bid--ask spread as a proxy for illiquidity. They document a positive relation between expected return and illiquidity. However, Eleswarapu and Reinganum (1993), who extended the sample period by 10 years, find that the existence of a positive liquidity premium is only limited to January. Brennan and Subrahmanyam (1996) examine the liquidity premium and find a positive return-illiquidity relation even after taking price, size and book to market factors into account in the Fama-French framework. Nevertheless, it is important to note that these authors consider liquidity as a stock characteristic rather than an aggregate risk factor of concern to investors.
The recent relative consensus about the existence of commonality in liquidity raises a new question about the role of liquidity in asset pricing. Therefore, commonality in liquidity could represent a source of non-diversifiable risk, and, in that case, the sensitivity of an individual stock to liquidity shocks could induce the market to require a higher average return. Consistent with this proposition, several authors provide evidence that expected returns are positively related to market-wide liquidity or liquidity risk, such as Pastor and Stambaugh (2003), Amihud (2002), Acharya and Pedersen (2005), Miralles-Marcelo and Miralles-Quiros (2006), among others.
In their seminal paper, Acharya and Pedersen (2005) propose a liquidity-adjusted CAPM (LCAPM), in which a security required return depends on its expected liquidity, as well as on the co-variances of its own return and liquidity with the market return and liquidity. Using the Amihud (2002) illiquidity ratio and stock returns, these authors find some evidence that illiquidity betas are priced in the USA, and that their model is better than the standard CAPM in terms of goodness of fit. Other authors, such as Lee (2011), Papavassiliou (2013), Li et al. (2014) and Butt and Virk (2015) also use the Acharya and Pedersen (2005) model to study the relationship between stock returns and liquidity, respectively.
The work of Lee (2011) is different, as he empirically tests the LCAPM of Acharya and Pedersen (2005) on a global level. The empirical evidence presented is supportive of the LCAPM, in which liquidity risks are priced independently of market risk in international financial markets.
Li et al. (2014) use data from the second largest equity market, Japan, to test whether liquidity and liquidity risk are priced. In consistent with the findings of Acharya and Pedersen (2005) in the USA, these authors also report evidence that the liquidity-adjusted CAPM is superior to standard CAPM but they only obtain weak evidence for the argument that liquidity risk is priced in addition to the liquidity level and the market risk.
The Acharya and Pedersen (2005) model was also tested in other developed yet small stock markets, such as Greece and Finland. For the Greek stock market, Papavassiliou (2013) provides evidence that liquidity risk is a priced factor, mainly arising from the covariation of individual liquidity with local market liquidity, and that the level of liquidity seems to be an irrelevant variable in asset pricing. Butt and Virk (2015) use the proportion of the zero-returns illiquidity measure, in addition to the Amihud (2002) illiquidity ratio, to report evidence that a substantial risk premium related to illiquidity risk exists in the Finnish market, and that a liquidity-adjusted CAPM performs better than simple CAPM specifications.
Although this strand of the financial literature is boundless, prior evidence for the Portuguese stock market is scarce. The initial works of Escalda (1993) and Mello and Escalda (1994) were focused on analysing the role of individual liquidity in asset pricing for a sample period in which the Portuguese market was an emerging market. However, subsequent studies, such as those of Pereira and Cutelo (2013) and Miralles-Marcelo et al. (2015), have focused on other aspects of liquidity. More precisely, Pereira and Cutelo (2013) observe that low-price stocks are less liquid than high-price stocks and trade at lower valuation ratios. Finally, they argue that their results do not support any of the existing theories on optimal price per share. On the other hand, Miralles-Marcelo et al. (2015) analyse whether there exists commonality in liquidity in the Portuguese market over the 1988-2011 period. Following the Chordia et al. (2000) methodology, some evidence of commonality in liquidity is found in the Portuguese market when the proportion of zero returns is used as a measure of liquidity. However, they do not take into account the change from an emerging to a developed market.
In this context, in the present study for the Portuguese stock market, we analyse the effects of liquidity in asset pricing, both as an individual characteristic of financial assets, like the initial studies, and as a source of systematic risk, like more recent studies. Moreover, we analyse possible changes affected by the evolution of this market into a developed one.
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Data
In this study...
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