Jegadeesh, Narasimhan, and Sheridan Titman

Liquidity Risk and Expected Stock Returns

ˇ
Lubos Pa
ˇ ´stor
University of Chicago, National Bureau of Economic Research, and Centre for Economic Policy
Research

Robert F Stambaugh
.
University of Pennsylvania and National Bureau of Economic Research

This study investigates whether marketwide liquidity is a state variable important for asset pricing. We find that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Our monthly liquidity measure, an average of individual-stock measures estimated with daily data, relies on the principle that order flow induces greater return reversals when liquidity is lower. From 1966 through 1999, the average return on stocks with high sensitivities to liquidity exceeds that for stocks with low sensitivities by 7.5 percent annually, adjusted for exposures to the market return as well as size, value, and momentum factors. Furthermore, a liquidity risk factor accounts for half of the profits to a momentum strategy over the same 34-year period.

Research support from the Center for Research in Security Prices and the James S.
Kemper Faculty Research Fund at the Graduate School of Business, University of Chicago, is gratefully acknowledged (Pastor). We are grateful for comments from Nick Barberis,
´
John Campbell, Tarun Chordia, John Cochrane (the editor), George Constantinides, Doug
Diamond, Andrea Eisfeldt, Gene Fama, Simon Gervais, David Goldreich, Gur Huberman,
Michael Johannes, Owen Lamont, Andrew Metrick, Mark Ready, Hans Stoll, Dick Thaler,
Rob Vishny, Tuomo Vuolteenaho, Jiang Wang, and two anonymous referees, as well as workshop participants at Columbia University, Harvard University, New York University,
Stanford University, University of Arizona, University of California at Berkeley, University of Chicago, University of Florida, University of Pennsylvania, Washington University, the
Review of Financial Studies Conference

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