Liquidity and stock returns: an alternative test

Finance

IFA Working Paper

Datar V; Naik N Y; Radcliffe R

Narayan Naik

1997

This paper provides an alternative test of Amihud and Mendelson's (1986, Journal of Financial Economics, 8, 31-35) model using the turnover rate (number of shares traded as a fraction of the number of shares outstanding) as a proxy for liquidity. The evidence suggests that liquidity plays a significant role in explaining the cross-sectional variation in stock returns. This effect persists after controlling for the well known determinants of stock returns like the firm-size, book-to-market ratio and the firm beta. Unlike Eleswarapu and Reinganum (1993, Journal of Financial Economics, 34, 373-386), this paper finds that the liquidity effect is not restricted to the month of January alone and is prevalent throughout the year. The evidence supports Amihud and Mendelson's (1986) notion of liquidity premium and establishes its role in the overall cross section of stock returns.

Institute of Finance and Accounting

FIN 249

IFA Working Paper

No