An illiquidity premium in stock returns? - Evidence from the Stockholm Stock Exchange

Abstract

Asset pricing models generally do not take into account differences across securities in trading costs or liquidity. Yet, in the recent past, numerous studies have found evidence of an illiquidity premium in stock returns on the US stock markets. It has also been tried to explain the small company effect with the help of differences in trading costs and liquidity. The purpose of this present study is, first, to describe the concept of liquidity, to discuss ways how to measure liquidity, and to review previous research with respect to illiquidity premiums in stock returns. Second, the purpose is also to investigate empirically whether the level of implicit trading costs and illiquidity contributes to the explanation of the cross-sectional variation in stock returns on the Stockholm Stock Exchange during the period from 1995 to 2004. This is done with the help of a portfolio analysis, cross-sectional regressions, and regressions that pool cross-sectional and timeseries data. Only weak empirical evidence of an illiquidity premium in stock returns on the Stockholm Stock Exchange is found. No support of a small company effect that could have been explained with differences in trading costs is found.