State-Dependent Variations in the Expected Illiquidity Premium

Abstract

Recent evidence on state-dependent variations in market liquidity suggests strong variations in the illiquidity premium across economic states. Adopting a two-state Markov switching model, we find that, while illiquid stocks are affected more by economic conditions than liquid ones are during recessions, the differences in expected returns are relatively small during expansions. Therefore, the expected illiquidity premium displays strong state-dependent variations that are countercyclical. We show that the state of a high illiquidity premium is closely associated with periods of real economic recessions, market declines, and high volatility, which coincides with major events of liquidity dry-up and high liquidity commonality.