Index revisions, systematic liquidity risk and the cost of equity capital

Abstract

This study investigates the impact of FTSE100 index revisions on firms' systematic liquidity risk and the cost of equity capital. We show that index membership enhances all aspects of liquidity, whereas stocks that leave the index exhibit no significant liquidity change. We also show that the liquidity risk premium and the cost of equity capital decline significantly after additions, but do not exhibit any significant change following deletions. The control sample analysis indicates that observed decline in liquidity premium and the cost of equity capital is not driven by factors other than index revisions. Our evidence is consistent with Amihud and Mendelson's (1986) argument that since liquidity is priced, an increase in liquidity will result in lower expected returns. Furthermore, the asymmetric impact of additions and deletions on stock liquidity and cost of capital is consistent with the view that the benefits of index membership are permanent (see, e.g. Chen et al. 2004Chen et al. , 2006. JEL Classification: G12, G32

Index Revisions, Stock Liquidity and the Cost of Equity Capital

“…The result is contrary to what should have happened otherwise; that is, the COEC should have declined for inclusion firms and increased for exclusion firms. Further, this result is inconsistent with (Baran & King, 2012;Becker-Blease andPaul, 2006, 2010;Biktimirov & Li, 2014;Elliott et al, 2006;Hegde & McDermott, 2003;Mazouz et al, 2014) who report that, for inclusion firms, an increase in liquidity leads to decrease in the cost of capital, and for exclusion firms, a decrease in liquidity leads to an increase in the cost of capital.…”

“…The results of inclusions and exclusions are contrary to the previous studies of Baran and King (2012) who reported a decrease in the COEC for the inclusion firms and an increase in the COEC for the exclusion firms of the S&P 500 index. Similarly, Mazouz et al (2014) also reported a decline in the COEC post-inclusion and no change in the COEC post-exclusion for the FTSE 100 index revisions. Moreover, the results of the COEC are in accordance with the results reported for stock liquidity in Section "Liquidity Effects of Stock Index Revisions" of this article.…”

“…Their study holds the LCH to be true for both the added and deleted stocks. Mazouz, Daya and Yin (2014) investigated the effect of FTSE 100 index revisions on firm's systematic liquidity risk and the COEC. They reported that stock liquidity increased after inclusion, while there is no change in liquidity following exclusions.…”

“…Hegde and McDermott (2003), Becker-Blease and Paul (2006), Elliott et al (2006) examined the S&P 500 index revisions, and their impact on stock price and volume, and documented an increase (decrease) in stock liquidity, and argued that it decreases (increases) the cost of capital of a firm. Similarly, Baran and King (2012) and Mazouz et al (2014) investigated the liquidity and the COEC changes around index revisions. Both of them found significant changes for inclusions.…”

Disruptive Innovations, Fundamental Strength and Stock Winners: Implications for Stock Index Revisions

“…Prior work provides evidence that the index revisions significantly impact the stock performance. Studies (Baran & King, 2012; Becker-Blease & Paul, 2006, 2010; Biktimirov & Li, 2014; Chan et al, 2013; Chen et al, 2004; Dhillon & Johnson, 1991; Edmister et al, 1996; Elliott et al, 2006; Fernandes & Mergulhão, 2016; Gregoriou, 2011; Gregoriou & Nguyen, 2010; Hegde & Mc Dermott, 2003; Hrazdil, 2009; Kamal, 2014; Kot et al, 2015; Mazouz et al, 2014; Miller & Ward, 2015; Sadeghi, 2011) have analysed the effect of index reorganization on the liquidity, cost of equity capital and abnormal rate of return in the international context. Afego (2017) presents a detailed review of studies related to changes in index compositions.…”