Liquidity and stock returns: Evidence from Denmark

Rune Dalgaard

Student thesis: Master thesis


This master's thesis examines the relationship between liquidity and stock returns theoretically and empirically. This thesis considers stock liquidity as a scale rather than a level. The main hypothesis of the empirical study of this thesis is that stock returns are decreasing in liquidity. This hypothesis is backed by a rigorous, theoretical model that will be derived. The hypothesis can, however, be explained by intuition - if investors are to hold stocks that cannot easily be sold without changing the price or incurring other costs, they should demand compensation. This compensation is expected to come in higher returns. Thus, investors are expected to require higher returns for less liquid stocks. In addition to this, stocks with returns that are sensitive to changes in liquidity should yield higher returns to compensate the investors for this additional risk. Previously, the liquidity-return relationship has been investigated in a number of studies. To mention a few, Amihud and Mendelson (1986), Datar, Naik, and Radcliffe (1998), Chan and Faff (2005), and Archarya and Pedersen (2005) all find clear evidence of the pricing of liquidity or liquidity risk in equity markets. The empirical study of this thesis is based on a sample of listed Danish companies for the time period from 1987 through November 2008. Two measures of liquidity are applied - the relative bidask spread and the turnover rate. In a cross-sectional framework a la Fama and Macbeth (1973), the cross-sectional effect of liquidity on stock returns is studied for both measures of liquidity. Also, the cross-sectional relationship between liquidity risk and stock pricing is studied. For both studies a number of robustness checks are carried out to determine the robustness of the findings. The empirical study provides ambiguous evidence of the pricing of liquidity and liquidity risk in Denmark. No findings are robust to changing various assumptions or calculation techniques. Overall, there is neither strong evidence of a return premium for illiquidity nor a return premium for liquidity risk. There are, however, indications of  an annualised illiquidity return premium in the range 400 - 520bp per 100bp of increase in the relative spread,  an annualised illiquidity return premium in the range 62 - 71bp per 100bp decrease in the turnover rate,  a liquidity risk premium in the range 570 - 590bp per unit of relative bid-ask spread sensitivity, and  a liquidity risk premium of approximately 1080bp per unit of turnover rate sensitivity The findings are not robust, so they should be considered with a certain amount of criticism. However, the findings still give an indication of the relationship between liquidity and stock returns in Denmark.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
Publication date2009
Number of pages151