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Role of Liquidity in Explaining Anomalous Returns: Evidence from Emerging Market

Mohsin Sadaqat () and Hilal Anwar Butt
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Mohsin Sadaqat: National University of Science & Technology, Islamabad
Hilal Anwar Butt: Institute of Business Administration, Karachi

Business & Economic Review, 2017, vol. 9, issue 3, 1-35

Abstract: This study investigated the role of liquidity in explaining the size and volatility related anomalies in Pakistan Stock Exchange (PSX), Pakistan. Using firm level data from 1993 until 2015, it is identified that these anomalies offer 30% to 50% annual returns in PSX. These returns are quite higher in comparison to comparable evidence for the most efficient market of the US. Furthermore, we rationalized these returns within the framework of Efficient Market Hypothesis (EMH). For this purpose, Liquidity Augmented Capital Asset Pricing Models (LCAPM) proposed by (Acharya & Pederson, 2005) has been used. Results indicate that higher returns are not a vindication of market inefficiency rather, a compensation to investors for being exposed to market and illiquidity related local risks. Moreover, this study also investigated the existence of diversification opportunities in PSX. It is found that PSX provides significant portfolio diversification opportunities to the international investors. These results are also replicated for other two relatively bigger emerging markets of India and Brazil with lesser diversification benefits. Results of this study indicate that liquidity is an important factor in pricing the return structure of equities in PSX. Investors should consider liquidity as a factor in asset pricing models to value their stocks/portfolios more efficiently.

Keywords: Zero-investment strategy; annual returns; Pakistan Stock Market; market risk; illiquidity risk; diversification. (search for similar items in EconPapers)
JEL-codes: G10 G12 G15 (search for similar items in EconPapers)
Date: 2017
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Handle: RePEc:bec:imsber:v:9:y:2017:i:3:p:1-35