Liquidity, Asset Pricing and the Cost of Capital
Stephan K. H. Simon
Liquidity, Asset Pricing and the Cost of Capital
Mattias Andersson
Lund University
Jesper Berthelson
Lund University
Stephan Simon
Universität Passau
Contact: Stephan Simon <mailto:si...@winf.uni-passau.de>
URL: http://www.winf.wiwi.uni-passau.de/new/personal/simon/papers/papws1.html#liquid
Comments: This work was created as a Thesis at the School of Management
and Economics of Lund University. We would welcome any kind of comment
and feedback very much.
JEL Classification: G12
Keywords: Bid-ask spread, Illiquidity cost, Investment horizon, Liquidity/Illiquidity,
Liquidity effect, Market impact cost
In our thesis we investigate and quantify, for the Stockholm Stock
Exchange, an effect neglected by existing financial research - the
illiquidity effect, measurable as the cost of immediacy represented by
the bid-ask spread and the market impact cost in the form of abnormal
returns from the relative market risk model (CAPM).
We derive the simple theoretical relationships that should prevail
between our measurable variables and the expected return - the return is
a positive, concave function of the relative bid-ask spread. This we
test with a series of regressions embedded in a comprehensive model
including also the relative market risk. First, we test the linear
relationship of the bid-ask spread and the return, which we can
establish on a significant level. On an annual basis a
1-percentage-point change in the relative spread leads to a change of
3.35% in the expected return.
Then we can also observe that this function is tendentious concave in
reality. This has grave implications for corporate financial management
as a reduction of the relative bid-ask spread for an already low spread
stock results in an above proportional decrease in the cost of capital
for this company.
In another regression we can quantify the annual effect of the market
impact cost to be about the same magnitude as the bid-ask spread effect.
Finally, a regression of the bid-ask spread on the percentage of days
traded and the relative turnover proves the bid-ask spread to be a good
proxy for the cost of immediacy. Indirectly we can also show that
increasing relative spreads result in longer holding periods.