The objective of this paper is to investigate various channels through which liquidity can affect stock returns. Sample includes all non-financial firms listed in the Korean stock market for the period 1993~2004. First, I examine whether the liquidity level (average liquidity) plays a significant role in determining asset returns. The result supports the hypothesis that a stock with higher average illiquidity will have a higher expected return. Second, I focus on the argument that liquidity has a non-diversifiable systematic component. If liquidity commonality has a different impact across individual securities, a stock that is more sensitive to systematic liquidity will have a higher expected return. The result shows that a stock with higher return sensitivity to systematic liquidity outperforms lower sensitivity stock, coinciding with the result of Pastor and Stambaugh (2003). Korea also provides good conditions to examine whether the behavioral explanations for liquidity risk are reasonable. The fact that the Korean market has high liquidity compared to other markets and is dominated by individual investors gives a clue that high liquidity is related to investors’ irrationality. The inter-market comparison between Korea and the U.S. shows that the liquidity premium in Korea is higher than that in the U.S., and that this premium cannot be fully explained by information asymmetry risk. The intra-market test is also performed, using the investor classification data. A portfolio which is traded more frequently by individual investors contains a stronger effect of liquidity. In conclusion, the inter-market comparison with the U.S. and the intra-market test show that a substantial portion of the liquidity premium is attributable to investor sentiment and irrational behavior. The evidence in this paper supports the behavioral explanations for the liquidity premium.
Keywords: Liquidity level, Systematic liquidity, Sensitivity, Asset returns, Investor behavior