Liquidity Risk and Stock Returns: A Return Decomposition Approach

44 Pages Posted: 18 Sep 2012 Last revised: 11 Mar 2013

See all articles by Shaun A. Bond

Shaun A. Bond

UQ Business School

Qingqing Chang

Office of the Comptroller of the Currency

Date Written: February 10, 2013

Abstract

We study the effect of innovations in liquidity on stock-return volatility under the return-decomposition framework. Using revisions to equity analyst consensus forecasts to measure cash-flow news directly, we contend that both cash-flow news and expected return news correlate with liquidity shocks, and the cash-flow news component is a nontrivial channel through which liquidity correlates with stock returns. Specifically, we find a positive (decrease) liquidity shock for firms that have positive (negative) cash-flow news and expected-return news. Furthermore, since the correlation between liquidity proxies and stock returns also arise from the association of liquidity proxies with the three stock return components, the R^2 from a regression of returns on liquidity proxies may understate or overstate the importance of liquidity as a source of stock-return variance. Finally, liquidity proxies tend to explain stock returns better during negative market liquidity shocks, but this additional explanatory power comes mostly from the increased correlation between liquidity proxies and cash-flow news, while the correlation between liquidity proxies and unexplained stock return variations does not change with market liquidity conditions.

Keywords: Liquidity Risk, Cash-flow news, Expected-return news

JEL Classification: G12

Suggested Citation

Bond, Shaun Alexander and Chang, Qingqing, Liquidity Risk and Stock Returns: A Return Decomposition Approach (February 10, 2013). Midwest Finance Association 2013 Annual Meeting Paper, Available at SSRN: https://ssrn.com/abstract=2148729 or http://dx.doi.org/10.2139/ssrn.2148729

Shaun Alexander Bond

UQ Business School ( email )

The University of Queensland
Brisbane, QLD 4072
Australia

Qingqing Chang (Contact Author)

Office of the Comptroller of the Currency ( email )

400 7th St. SW
Washington, DC 20219
United States

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