Market Illiquidity and Conditional Equity Premium

We examine the time-series relation between aggregate bid-ask spreads and conditional equity premium. We document that average marketwide relative effective bid-ask spreads forecast aggregate market returns only when controlling for average idiosyncratic variance. This control allows us to document...

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Bibliographic Details
Published in:Financial management 2017-09, Vol.46 (3), p.743-766
Main Authors: Guo, Hui, Mortal, Sandra, Savickas, Robert, Wood, Robert
Format: Article
Language:English
Subjects:
Asked price
Asset pricing
Bias
Economic models
Equity
Equity (Finance)
Financial management
Financial research
Liquidity (Finance)
Markets (Economics)
Securities markets
Spread
Time series
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Summary:We examine the time-series relation between aggregate bid-ask spreads and conditional equity premium. We document that average marketwide relative effective bid-ask spreads forecast aggregate market returns only when controlling for average idiosyncratic variance. This control allows us to document the otherwise elusive relation between illiquidity and returns. The reason is that idiosyncratic variance correlates positively with spreads but has a negative effect on conditional equity premium, causing an omitted variable bias. Our results are robust to standard return predictors, alternative illiquidity measures, and out-of-sample tests. These findings are important because they provide strong support for the literature's conjecture that marketwide liquidity is an important asset pricing risk factor.
ISSN:0046-3892
1755-053X
DOI:10.1111/fima.12162