RFS Advance Access originally published online on July 24, 2007
Review of Financial Studies 2007 20(6):1783-1831; doi:10.1093/rfs/hhm030
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Liquidity and Expected Returns: Lessons from Emerging Markets
Columbia University, National Bureau of Economic Research
Duke University, National Bureau of Economic Research
University of North Carolina at Chapel Hill
Address correspondence to Campbell R. Harvey, Fuqua School of Business, Duke University, Durham, NC 27708, or e-mail: cam.harvey{at}duke.edu
JEL: G12, G15, F30
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Abstract |
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Given the cross-sectional and temporal variation in their liquidity, emerging equity markets provide an ideal setting to examine the impact of liquidity on expected returns. Our main liquidity measure is a transformation of the proportion of zero daily firm returns, averaged over the month. We find that it significantly predicts future returns, whereas alternative measures such as turnover do not. Consistent with liquidity being a priced factor, unexpected liquidity shocks are positively correlated with contemporaneous return shocks and negatively correlated with shocks to the dividend yield. We consider a simple asset-pricing model with liquidity and the market portfolio as risk factors and transaction costs that are proportional to liquidity. The model differentiates between integrated and segmented countries and time periods. Our results suggest that local market liquidity is an important driver of expected returns in emerging markets, and that the liberalization process has not fully eliminated its impact.
We thank Dixon Lin and Sam Henkel for providing helpful research assistance. This paper has benefited from discussions with and comments from Laurie Hodrick, Chuck Trzcinka, Andrew Ellul, Costas Constantinou, Marco Pagano, Mark Seasholes, Darius Miller, Maureen O'Hara, and participants at the 2003 European Finance Association Meetings, 2004 American Finance Association Meetings, 2004 UCLA CIBER Doctoral Internationalization Consortium in Finance, and the 2005 Darden Emerging Market Finance Conference. We are especially grateful for the comments of two anonymous referees which greatly improved the article.
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