Market Frictions - Market liquidity as a priced risk factor
3 important questions on Market Frictions - Market liquidity as a priced risk factor
What do Pastor and Stambaugh (2003) test?
- Whether illiquidity is priced
- do investors demand extra return for bearing liquidity risk?
- Specifically: is the sensitivity of a stock to market wide liquidity priced?
- Positive relation between liquidity and welfare
- Liquidity is low when investors need to sell to raise cash
- Liquidity is a RISK factor
How can we interpret the formula used by Pastor and Stambaugh?
- If the sign of the return is positive, and there is high volume
- we expect gamma to be negative; the price was pushed up to much do to lack of liquidity -> gamma compensates for this in the next period and thus return in T is negatively correlated with liquidity in T-1
How did Pastor and Stambaugh measure liquidity?
- For each month for each stock a gamma is obtained
- If the stock is not perfecttly liquid, volume pushes price up too much -> reversal next period
- Expect gamma to be negative and larger (abs) for more illiquid stocks
- Take the average gamma for each month as the measure of market illiquidity from 1962-1999
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