Liquidity is valuable to investors. Therefore, investors demand higher expected returns for less liquid stocks. The liquidity of an asset market refers to the ability of investors to buy and sell significant quantities of that asset, quickly, at low cost and without a major price concession.
Thus, liquidity risk can be thought of as the risk to investors that an investment cannot be bought or sold quickly enough to prevent or minimize a loss. The size of the bid/offer spread and the amount of daily volume are frequently used as measures, or indicators, of liquidity risk.
An important question is whether investors demand higher returns from less liquid securities. The academic literature includes a number of studies showing that liquidity risk is indeed priced into expected returns. In other words, investors do require higher expected returns for stocks with greater bid/ask spreads to offset higher trading costs.
The Truth About Liquidity
For example, the authors of a 2010 study, “Liquidity as an Investment Style,” found that liquidity, as measured by stock turnover or trading volume, is an economically significant investment that remains distinct from traditional investment styles such as size, value/growth and momentum.
The literature also shows that sell-order illiquidity is priced more strongly in the cross section of expected equity returns than is buy-order illiquidity. In fact, the liquidity premium in stocks emanates predominantly from the sell-order side. This was the finding of the authors of a 2012 study, “Sell-Order Illiquidity and the Cross-Section of Expected Stock Returns.”
The literature provides us with yet another risk-based insight on the liquidity premium. The authors of a 2010 study, “Pricing Liquidity Risk and Cost in the Stock Market: How Different Was the Financial Crisis?”, concluded that markets require a higher premium for liquidity sacrifice in negative environments. Investors who hold illiquid stocks and become liquidity takers (through divesting them, either to meet liquidity needs or due to panicked selling) pay a steep price to do so.
They also found that unexpected illiquidity costs always have a larger influence on excess returns than expected illiquidity costs, in cases of both boom and crisis. Their explanation was that investors react more forcibly to the unknown liquidity shocks than to the predictable illiquidity costs. Thus, an additional premium is required for the cost embedded in the unexpected part of illiquidity.