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Title: Liquidity and Expected Returns: Lessons from Emerging Markets

Author(s): Geert Bekaert, Campbell Harvey and Christian T Lundblad

Publication Date: November 2006

Keyword(s): emerging markets, liquidity pricing and return predictability

Programme Area(s): Financial Economics

Abstract: Given the cross-sectional and temporal variation in their liquidity, emerging equity markets provide an ideal setting to examine the impact of liquidity on expected returns. Our main liquidity measure is a transformation of the proportion of zero daily firm returns, averaged over the month. We find that our liquidity measures significantly predict future returns, whereas alternative measures such as turnover do not. Consistent with liquidity being a priced factor, unexpected liquidity shocks are positively correlated with contemporaneous return shocks and negatively correlated with shocks to the dividend yield. We consider a simple asset pricing model with liquidity and the market portfolio as risk factors and transaction costs that are proportional to liquidity. The model differentiates between integrated and segmented countries and time periods. Our results suggest that local market liquidity is an important driver of expected returns in emerging markets, and that the liberalization process has not fully eliminated its impact.

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Bibliographic Reference

Bekaert, G, Harvey, C and Lundblad, C. 2006. 'Liquidity and Expected Returns: Lessons from Emerging Markets'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=5946