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Liquidity Shocks and Stock Market Reactions

Author

Listed:
  • Turan G. Bali

    (McDonough School of Business, Georgetown University)

  • Lin Peng

    (Zicklin School of Business, Baruch College)

  • Yannan Shen

    (Zicklin School of Business, Baruch College)

  • Yi Tang

    (Schools of Business, Fordham University)

Abstract
This paper investigates how the stock market reacts to firm level liquidity shocks. We find that negative and persistent liquidity shocks not only lead to lower contemporaneous returns, but also predict negative returns for up to six months in the future. Long-short portfolios sorted on past liquidity shocks generate a raw and risk-adjusted return of more than 1% per month. This economically and statistically significant relation is robust across alternative measures of liquidity shocks, different sample periods, and after controlling for various risk factors and firm characteristics. Furthermore, the documented effect is stronger for small stocks, stocks with low analyst coverage and institutional holdings, and for less liquid stocks. Our evidence suggests that the stock market underreacts to firm level liquidity shocks, and that this underreaction can be driven by investor inattention as well as illiquidity.

Suggested Citation

  • Turan G. Bali & Lin Peng & Yannan Shen & Yi Tang, 2013. "Liquidity Shocks and Stock Market Reactions," Koç University-TUSIAD Economic Research Forum Working Papers 1304, Koc University-TUSIAD Economic Research Forum.
    • Handle: RePEc:koc:wpaper:1304
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    File URL: http://eaf.ku.edu.tr/sites/eaf.ku.edu.tr/files/erf_wp_1304.pdf
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    3. Jozef Barunik & Martin Hronec & Ondrej Tobek, 2024. "Predicting the distributions of stock returns around the globe in the era of big data and learning," Papers 2408.07497, arXiv.org.
    4. Zhu, Zhaobo & Sun, Licheng & Yung, Kenneth & Chen, Min, 2020. "Limited investor attention, relative fundamental strength, and the cross-section of stock returns," The British Accounting Review, Elsevier, vol. 52(4).
    5. Meskat Ibne Sharif, 2023. "Parametric test of liquidity wavering in response to the dynamic equity constituents," SN Business & Economics, Springer, vol. 3(1), pages 1-26, January.
    6. Tobek, Ondrej & Hronec, Martin, 2021. "Does it pay to follow anomalies research? Machine learning approach with international evidence," Journal of Financial Markets, Elsevier, vol. 56(C).
    7. Guo, Laite, 2023. "Two faces of the size effect," Journal of Banking & Finance, Elsevier, vol. 146(C).

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    More about this item

    Keywords

    Stock returns; liquidity shocks; stock market reactions; underreaction; investor attention.;
    All these keywords.

    JEL classification:

    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General

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