Liquidity and the Cross-Sectional Variation in
A five-factor model was used to investigate the relationship between liquidity and equity returns and the existence of liquidity premiums in Pakistan. Different asset pricing models, including the Capital Asset Pricing Model, the Fama-French Three-Factor Model, the Carhart Four-Factor Model, and the five-factor model with liquidity as the fifth factor, were tested to explain variations in stock returns.
We used three measures of liquidity: stock turnover, illiquidity cost following Amihud (2002), and liquidity beta following Pastor and Stambaugh (2003), and created the size, book-to-market, momentum, and liquidity factors using one-dimensional quintile and decile portfolios and sequentially sorted portfolios. Various asset pricing tests were conducted using the data from 2001 to 2015 for 134 non-financial firms listed on the Pakistan Stock Exchange.
The study found the existence of market, size, BM, momentum, and liquidity premiums in Pakistan’s equity market; however, market risk remains the most significantly priced factor. Further, the relationship between the liquidity factor and stock returns was not consistent for the different measures used. Stock turnover and returns were found to be positively related; however, a negative relationship between liquidity and returns was confirmed using the Amihud illiquidity cost and Pastor and Stambaugh liquidity beta.
Factors related to cross-sectional variations in stock returns that are popular in the literature are also priced in Pakistan’s emerging equity market; however, this study considered only five explanatory stock return factors from 2001 to 2015 for surviving firms in Pakistan. The investigation of other fundamental factors, the comparison of factor premiums in different markets, and the use of high frequency stock transaction data to construct the liquidity measure remain areas of future research.
Investors in Pakistan’s stocks can earn high returns by appropriately selecting the issues based on positively priced risk factors. Specifically, the stock of small firms with high BM and high market risk can yield high returns. Moreover, investors do not necessarily have to trade in illiquid stocks to capture high yields as stocks with high turnovers offer higher returns.
This study is the first to conduct a comprehensive analysis of various asset pricing models and to investigate the impact of liquidity on stock returns in Pakistan. From an emerging market perspective, the study provides out-of-sample evidence on the validity of various asset pricing models.
Liquidity, stock returns, asset pricing models, Pakistan Stock Exchange, emerging market