Stock Liquidity and Investment Opportunities: Evidence from Index Additions

Abstract

We examine the relation between stock liquidity and investment opportunities in a sample of firms experiencing an exogenous liquidity shock. We find a positive relation between changes in capital expenditures and changes in stock liquidity, indicating that stock liquidity influences corporate investment decisions. This relation is robust to alternative measures of growth opportunities, and is consistent with a liquidity premium in equity returns. That is, an increase in liquidity effectively expands the set of positive NPV projects because it reduces the cost of capital. The results suggest that liquidity-enhancing events benefit shareholders by increasing the pool of viable growth opportunities. Copyright (c) 2006 Financial Management Association International.

Stock liquidity and investment opportunities: New evidence from FTSE 100 index deletions

“…First, this is the only study to empirically examine the relationship between stock liquidity and investment opportunities in a sample of firms experiencing a negative exogenous liquidity shock. It is very interesting to discover if stock liquidity influences corporate investment decisions when firms encounter exogenous liquidity shocks as a whole (Becker-Blease and Paul, 2006), or whether an asymmetry exists between positive and negative liquidity shocks.…”

“…Becker- Blease and Paul (2006) examine the empirical relationship between stock liquidity and investment opportunities in the context of additions to the S&P 500 stock index, over the time period of 1980-2000. Index revisions provide an exogenous liquidity shock because firms are selected on public information, including market value, industry grouping and fundamental analysis.…”

“…Second, Becker-Blease and Paul (2006) assume that company additions to the S&P 500 are determined exogenously. However, this may not be entirely true because eventhough market capitalization (firm size) is exogenous, public information (one of the criteria used to determine inclusion in the S&P 500) is to an extent discretionary implying an endogenous liquidity shock.…”

The perils of a central bank's capital control: How substantial is the effect on firm value?

“…Drawing upon the literature suggesting that there exists a liquidity premium in stock returns (see e.g. Becker-Blease and Paul, 2006), we argue that if the market considers the imposition of capital controls as a source of an exogenous liquidity shock (i.e. greater financial constraints in the domestic financial markets (see e.g., Cordella, 2003)), the subsequent fall of stock prices would be consistent with the prediction of the liquidity premium theory.…”

“…If we consider the imposition of a capital control as a source of an exogenous liquidity shock that reduces the availability of foreign financial capital in a small and open country, the theory of a liquidity premium in asset returns (see e.g., Becker-Blease and Paul, 2006;He and Xiong, 2012) would predict an inverse effect of the imposition of a capital control on firms' future prospect. For instance, He and Xiong (2012) show that a fall in debt market liquidity results in an increase in the liquidity premium of corporate bonds and credit risk.…”