Liquidity and Stock Returns: Evidence from the UK Market

Following Amihud and Mendelson (1986) and Datar et al. (1998), most empirical evidence from US market reveal that stock returns should be an increasing function of bid-ask spread and a decreasing function of turnover rate, confirming the existence of a positive liquidity premium. This paper conducts a detailed analysis of liquidity effect on stock returns in the UK stock market over period January 1993 to December 2008. The results from the cross-sectional regression approach reveals a significant positive return-spread relation limited to the month of January only, confirming the evidence of Eleswarapu and Reinganum (1993). Conflicted with the majority of the existing literature (e.g., Datar et al., 1998), a highly significant but positive return-turnover relationship is evident. This liquidity effects persists even after controlling for the size and book-to-market effect. The time-series regression analysis shows weak evidence of liquidity premium associated with both bid-ask spread and turnover rate, robust to subperiod and seasonality analysis. With regard to the conflicting results with the existing literature, I argue that both bid-ask spread and turnover rate to be poor liquidity proxies, or the US evidence may not be a world-wide phenomenon