Market pricing of liquidity risk: evidence from China

Purpose - The purpose of this paper is to investigate whether liquidity risk (i.e. the returns’ vulnerability to the unexpected changes in overall market liquidity) is a priced risk factor in China. Moreover, it investigates the potential role of a stock’s information quality in reducing its liquidity risk during the period of post-non-tradable shares reforms in China. Design/methodology/approach - The authors collect data of all the A-share issuing firms listed either on the Shanghai Stock Exchange or Shenzhen Stock Exchange during the period 2006–2016. The authors perform two-stage cross-sectional regression testing. First, the authors perform firm-specific time-series regressions of excess returns over Fama–French’s three-factor model and a liquidity factor. Second, to test whether firm-specific liquidity risk is a priced risk factor, the authors apply Fama and MacBeth’s regressions. Findings - Firm-level asset pricing tests provide substantial evidence for market pricing of liquidity risk in China. The authors find a significant negative association between information quality and liquidity risk. The authors also find that the reduction in liquidity risk induced by better information quality is substantial enough to reduce required returns. These findings are robust to alternative measures of liquidity risk and information quality. Practical implications - The study underscores that a policy initiative to enhance the information environment can significantly reduce the market volatility in China. Originality/value - To the best of authors’ knowledge, this is the first study that considers the Shanghai Stock Exchange as well as Shenzhen Stock Exchange to investigate market pricing of liquidity risk in China.