Liquidity And Asset Pricing: Evidence From The Hong Kong Stock Market

1. Introduction

Investors face liquidity risk when they transfer ownership of

their securities. Therefore, investors consider liquidity to be an

important factor when making their investment decisions. Amihud

and Mendelson (1986) find a positive return-illiquidity relation.

Since that study, many other researchers continue to investigate

the return-illiquidity (liquidity) relation, but evidence over the

past two decades is generally inconsistent and mixed.1

Amihud (2002) shows that there is a significant relation between

liquidity and expected stock returns. He finds a negative return-

liquidity relation even in the presence of size, beta, and

momentum. The use of time-series models is important, because

it allows for an investigation of whether mimicking portfolios for

risk factors captures shared variation in stock returns and identifies

whether the model is well-specified.

Motivated by these studies, we address the question of

whether liquidity is an important variable to capture the shared

time-series variation in stock returns by investigating whether

the effect of liquidity on stock return remains after controlling

for the well-known stock return factors using Hong Kong data.

These well-documented factors are beta, size, and book-tomarket

ratio factors (the Fama–French three factors), momentum

factor, and the higher moment (coskewness) factor. Although

these are well-known factors and determinants in explaining

stock returns in the US market, previous studies seldom

examine their joint effect with liquidity in emerging and Asian

markets.2

Gathering out-of-sample evidence to support results beyond

the US market is important in avoiding the data-snooping problem

pointed out by Lo and MacKinlay (1990). Besides, the US market is

arguably the most liquid market in the world, with a smaller

liquidity effect than those of emerging or volatile markets. Investigating

the Hong Kong stock market, an important stock market

that ranked seventh in the world by market capitalization at the end of 2008, can help us understand the impact of liquidity on asset

pricing in emerging markets because the Hong Kong market is

known to be one of the most volatile stock markets in the world

and it is also well known to be dominated by small firms.3 Thus,

Hong Kong is an ideal out-of-sample testing ground for the returnliquidity

relation because liquidity (illiquidity) should affect expected

returns of many listed firms there.

In this paper, we adopt a time-series regression approach to

study the return-liquidity relation in Hong Kong. Previous studies

do not adequately address the relations among liquidity

and other important asset pricing factors in the Hong Kong

and Asian stock markets. We hope that by studying a highly volatile

market such as Hong Kong, we can find better and more robust

results on the return-liquidity (illiquidity) relation, which

helps to shed light on this issue in the literature. We employ

nine widely used liquidity (illiquidity) proxies in our study. We

adjust stock returns by the three-moment CAPM, the Fama–

French three-factor model, and the augmented Fama–French

three-factor models. Thus, we address the importance of liquidity

together with other known, important time-series determinants

of stock returns, such as beta, size, book-to-market ratio, and

momentum.

Our results show that liquidity is an important factor pricing

returns in Hong Kong after taking into consideration welldocumented

asset pricing factors. In particular, illiquid stocks

have positive loadings while liquid stocks have negative loadings

on

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