Liquidity, consumption, and the cross-sectional returns

Luo, Di (2014) Liquidity, consumption, and the cross-sectional returns. PhD thesis, University of Nottingham.

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My thesis attempts to examine the determinants of the cross-sectional stock returns. It mainly consists of three topics on the relation between consumption, stock liquidity, financial constraints, and expected returns.

The first is "Transaction costs, liquidity risk, and the CCAPM". I examine how the consumption-based capital asset pricing model (CCAPM) performs with transaction costs and liquidity risk adjustments. Using the effective trading costs of Hasbrouck (2009) and the high-low spread estimates of Corwin and Schultz (2012) as proxies for transaction costs, I find that a liquidity risk-adjusted CCAPM explains a larger fraction of the cross-sectional return variations than that of the traditional CCAPM. I show that my liquidity risk-adjusted model gives more plausible risk aversion estimates than the CCAPM.

The second is "The Liquidity risk adjusted Epstein-Zin model". In this chapter, I propose a liquidity risk adjustment to the Epstein and Zin (1989, 1991) model and assess the adjusted model's performance against the traditional consumption pricing models. I show that liquidity is a significant risk factor and it adds considerable explanatory power to the model. The liquidity-adjusted model produces both a higher cross-sectional R^2 and a smaller Hansen and Jagannathan (1997) distance than the traditional CCAPM and the original Epstein-Zin model. Overall, I show that liquidity is both a priced factor and a key contributor to the adjusted Epstein-Zin model's goodness-of-fit.

The third is "Financial constraints, stock liquidity, and stock returns". I examine the different impacts of stock liquidity on the stock returns across financially constrained and unconstrained firms due to different levels of information asymmetry. My results show that financial constraints are highly correlated with liquidity and liquidity risk. More importantly, stock liquidity is a significant determinant of the cross-sectional stock returns for financially constrained firms, but it is insignificant for unconstrained firms. In addition, stock liquidity is a main driver of the different relations between financial constraints and stock returns. The liquidity premium accounts for the positive constraint premium, but it cannot be subsumed by the constraint premium.

Item Type: Thesis (University of Nottingham only) (PhD)
Supervisors: Liu, W.
Li, X.
Keywords: Liquidity (Economics), consumption (Economics)
Subjects: H Social sciences > HG Finance
Faculties/Schools: UK Campuses > Faculty of Social Sciences, Law and Education > Nottingham University Business School
Item ID: 27605
Depositing User: Luo, Di
Date Deposited: 25 Feb 2015 14:23
Last Modified: 14 Sep 2016 03:27

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