Liquidity and Mispricing

Liquidity and Mispricing

Presented at:

  • 28th Bavarian Graduate Program of Economics meeting, University of Regensburg, July 2019
  • Macro-finance, monetary economics and international finance seminar, University of Tokyo, November 2019
  • Finance research seminar, Lund University, December 2019
  • 50th Anniversary Annual Meeting of the Financial Management Association (FMA), New York, October 2020

Scheduled:

  • 56th Annual EFA conference, Boston, April 2020 - cancelled due to COVID-19
  • 37th International Conference of the French Finance  Association (AFFI), Nantes, May 2020 - postponed to 2021 due to COVID-19
  • 29th European Financial Management Association conference (EFMA), Dublin, June 2020 -
    cancelled due to COVID-19

Abstract:

I document a strong liquidity premium in long/short portfolio returns based on the Stambaugh, Yu, and Yuan (2015) mispricing score. This premium can be mainly attributed to arbitrage asymmetry among very illiquid stocks. To explore this relation in greater detail, I analyze the effect of liquidity shocks on the magnitude of mispricing. In the the overall sample negative liquidity shocks lead to an increase in mispricing. Controlling for the state of the economy by means of the cross-sectional amount of positive and negative liquidity shocks on firm level, in a neutral market environment both negative and positive liquidity shocks lead to an increase in mispricing. In a strong market environment only negative liquidity shocks cause an increase in mispricing. Liquidity and liquidity shocks manifest as strong predictors of future returns, controlling for individual mispricing components as well as composite mispricing. These findings suggest that liquidity is an important determinant of mispricing on international equity markets.