Illiquidity Premium and Stylized Equity Returns

This study examines the relationship between illiquidity premium and equity returns in Pakistani equity market for the period 2000:6 to 2007:6 by using Fama and French (1992 and 1993) methodology. This is the first study that explores the relationship between illiquidity premium and equity returns in Pakistan by employing a large sample of more than 250 stocks listed on the Karachi Stock Exchange. An analysis of the results reveals that illiquidity premium is priced by market and it is significantly negatively related to equity market returns. It means that high liquidity stocks earn higher return in comparison to low liquidity stocks. Traditional Capital Asset Pricing Model (CAPM) is found to be valid as market factor is significant in explaining portfolio returns. However, the explanatory power of the two-factor model is 5% higher than the explanatory power of conventional CAPM. These results are in line with the findings of Hwang and Lu (2007) for the UK market and Eun and Huang (2007) for the Chinese equity market. However, empirical evidence contradicts that of Amihud and Mendelson (1986) who argue that low liquidity stocks earn higher return as compensation for taking illiquidity risk. As illiquidity premium exists in equity markets, so decision makers should consider it along with market premium in making decisions regarding investment, financing and valuation of financial instruments. The results are important, in the sense, that they can facilitate investors in efficient resource allocation.