We revisit the role of liquidity risk. We successfully replicate Pastor and Stambaugh’s (2003) gamma liquidity risk index, and within their time period, concur with their risk premium estimate. An out-of-their-time-period analysis finds post-time-period returns that are higher and pre-time-period returns that are lower than in-time-period returns. Modest variations to the index that are intended to improve power—such as value weighting, including zero volume days, including all stock price levels, and a modification intended to reduce estimation error—all cast doubt on whether the gamma premium is compensation for liquidity risk. We create five alternative liquidity risk indices from various popular liquidity proxies. Using time-series that start in either 1932 or 1968, none of the 10 specifications produce statistically significant risk premia.
Liquidity Risk?
Part of this work was completed by Pontiff while he was a Shimomura Fellow at the Development Bank of Japan. We thank George Aragon, Joel Hasbrouck, Jennifer Koski, Lubos Pastor, Ronnie Sadka, Robert Stambaugh, Kumar Venkataraman (referee), and Ivo Welch (editor) for valuable conversations. Lubos Pastor and Robert Stambaugh deserve special thanks for providing us with their original code. We thank Ming Lu for coding advice and Maximilan Papile for research assistance. SAS code that was used to generate this paper’s results is available on Jeffrey Pontiff’s Boston College website. Both co-authors are aware of concurrent work by Professor Robert Novy-Marx. We want our analysis to be independent and uninfluenced by Professor Novy-Marx’s paper. As such, we have not read his paper and we are unaware of his results.
Pontiff J, Singla R (2019), "Liquidity Risk?". Critical Finance Review, Vol. 8 No. 1-2 pp. 257–276, doi: https://doi.org/10.1561/104.00000075
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