Liquidity risk and expected returns in China’s stock market: A multidimensional liquidity approach

Liang Dong, Bo Yu, Zhenjiang Qin and Keith S.K. Lam

Research in International Business and Finance, 2024, vol. 69, issue C

Abstract: We propose a multidimensional liquidity measure constructed from 6 out of 17 individual low-frequency liquidity proxies. The multidimensional liquidity risk factor yields significant positive premiums and offers distinguished explanatory power on the cross-sectional return variations in China’s stock market. A six-factor liquidity (L-6F) model is the best-performing liquidity-embedded model for the Chinese market. The L-6F model outperforms the Fama and French (2015) five-factor model at explaining a series of return anomalies such as volatility, momentum, reversal, and skewness. Interestingly, the liquidity risk premium enlarges when market uncertainty escalates and systematic liquidity tightens, consistent with the “flight-to-liquidity” effect. Lastly, the multidimensional liquidity measure effectively captures high-frequency liquidity information and remains robust with alternative regression settings and liquidity estimation methods. The proposed multidimensional liquidity measure can be applied in liquidity risk management and liquidity-based trading strategies, and the L-6F model can be utilized in estimating risk-adjusted returns in China’s stock market.

Keywords: Multidimensional liquidity measure; Asymptotic principal component; Liquidity factor model; Flight-to-liquidity; Market uncertainty; China’s stock market (search for similar items in EconPapers)
JEL-codes: G12 G15 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:riibaf:v:69:y:2024:i:c:s0275531924000394

DOI: 10.1016/j.ribaf.2024.102247

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