Liquidity risk and expected stock returns in the KOSPI market

Abstract

This study investigates whether marketwide liquidity play an important role as a state variable in asset pricing. Expected stock returns are related cross-sectionally to the sensitivities of stock returns to fluctuations in aggregate liquidity in KOSPI market. This study uses the liquidity measure suggested by Pastor and Stambaugh(2003). The liquidity measure is based on the principle that lower order flow of buy of sell induces greater return reversals when the stock is less liquid. Using data from 1992 through 2007, we find that the expected returns of the stocks with high sensitivity to marketwide liquidity is higher than those of the stocks with low sensitivity, adjusted for exposures to the market return, size, value, and momentum factors. Furthermore, a liquidity risk factor explains the excess returns of momentum strategy over the last ten periods.