A new method for estimating liquidity and stock returns in Indian stock market

Abstract

PurposeThis study aims to explore the impact of systematic liquidity risk on the averaged cross-sectional equity return of the Indian equity market. It also examines the effects of illiquidity and decomposed illiquidity on the conditional volatility of the equity market.Design/methodology/approachThe present study employs the Liquidity Adjusted Capital Asset Pricing Model (LCAPM) for pricing systematic liquidity risk using the Fama & MacBeth cross-sectional regression model in the Indian stock market from January 1, 2012, to March 31, 2021. Further, the study employed an exponential generalized autoregressive conditional heteroscedastic (1,1) model to observe the impact of decomposed illiquidity on the equity market’s conditional volatility. The study also uses the Ordinary Least Square (OLS) model to illuminate the return-volatility-liquidity relationship.FindingsThe study’s findings indicate that the commonality between individual security liquidity and aggregate liquidity is positive, and the covariance of individual security liquidity and the market return negatively affects the expected return. The study’s outcome specifies that illiquidity time series analysis exhibits the asymmetric effect of directional change in return on illiquidity. Further, the study indicates a significant impact of illiquidity and decomposed illiquidity on conditional volatility. This suggests an asymmetric effect of illiquidity shocks on conditional volatility in the Indian stock market.Originality/valueThis study is one of the few studies that used the World Uncertainty Index (WUI) to measure liquidity and market risks as specified in the LCAPM. Further, the findings of the reverse impact of illiquidity and decomposed higher and lower illiquidity on conditional volatility confirm the presence of price informativeness and its immediate effects on illiquidity in the Indian stock market. The study strengthens earlier studies and offers new insights into stock market liquidity to clarify the association between liquidity and stock return for effective policy and strategy formulation that can benefit investors.