Stock Liquidity in the Context of Asset Pricing

Liquidity is a multifaceted concept in economics and finance. In asset pricing, liquidity refers to the ease with which an asset can be bought or sold; an asset is considered liquid if it can be readily transacted, and illiquid if it cannot. Fundamentally, asset pricing theory seeks to understand the prices or values of claims to uncertain payments. Liquidity matters for asset pricing through its effects on trading costs or price impacts: short-horizon investors face these costs upon trade execution, while long-horizon investors value liquidity to rebalance their portfolios. Moreover, assets are commonly exposed to market-wide liquidity shocks, and their sensitivity to such shocks constitutes a distinct source of liquidity risk. In this thesis, we examine stock liquidity viewed either as a firm characteristic or as a risk factor, and its implications for expected stock returns. Empirically, stock liquidity is multidimensional and is commonly measured by the bid– ask spread, price impact, and trading activity. The liquidity premium compensates investors not only for bearing illiquidity as a firm characteristic, but also for a stock’s sensitivity to market-wide liquidity shocks (Chapter 2). Firm-specific news sentiment exhibits a nonlinear relationship with stock liquidity, where moderate sentiment improves liquidity while extreme sentiment deteriorates it. Sentiment partially accounts for the liquidity premium, yet the component of liquidity orthogonal to sentiment retains a significant and independent role in determining stock returns (Chapter 3). Cross-listed A- and H-shares represent the same company with identical cash flow and voting rights, yet A-shares typically trade at a premium over their H-share counterparts. Relative liquidity differentials between the two markets are associated with a lower premium but greater persistence, with H-share liquidity playing a dominant role through its influence on arbitrage incentives (Chapter 4).