The role of liquidity factor in explaining the stock returns: New evidence from Tehran Stock Exchange

Document Type : Research Paper

Authors

1 Associate Professor, Faculty of Management and Accounting, Islamic Azad University, Firoozkuh Branch, Firoozkuh, Iran

2 MSc., Faculty of Management and Accounting, Islamic Azad University, Firoozkuh Branch, Firoozkuh, Iran

Abstract

This paper examines the role of liquidity factor in explaining the cross-section of stock returns of firms listed on Tehran Stock Exchange. The regression results of CAPM, Liu's two-factor model, the Fama-French three-factor model, and a Four-factor model in eight portfolios formed by Size, B/M Ratio, and Liquidity show that the two-factor (market and liquidity) model outperforms the CAPM in  explaining the cross-section of stock returns but not the Fama-French three-factor model. Adding liquidity premium to Fama-French three-factor model notably improves the adjusted R square of the model implying that all four factors of market, size, value, and liquidity play a significant role in explaining stock returns. The results are robust to sensitivity analyses for up and down market conditions and seasonal behavior.

Keywords


Abbasi, E. & Ghezeljeh, Gh. (2012). Examining Fama-French three-factor model in explaining portfolios' returns. Journal of accounting knowledge, 4(11): 161-180. (in Persian)
Amihud, Y. (2002). Illiquidity and stock returns: cross-section and time-series effects. Journal of Financial Markets, 5 (1): 31–56.
Amihud, Y. & Mendelson, H. (1986). Asset pricing and the bid-ask spread. Journal of Financial Economics, 17(2): 223–249.
Banz, Rolf, W. (1981). The Relationship between Return and Market Value of Common Stocks. Journal of Financial Economics, 9(1): 3-18.
Bartholdy, J. & Peare, P. (2005). Estimation of expected return: CAPM vs. Fama and French. International Review of Financial Analysis, 14(4): 407-427.
Basu, S. (1977). Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis. Journal of Finance, 32(3): 663-682.
Basu, S. (1983). The Relationship between Earnings Yield, Market Value, and Return for NYSE Common Stocks: Further Evidence. Journal of Financial Economics, 12(1): 129-156.
Bhandari, L. C. (1988). Debt /equity ratio and expected common stock returns: Empirical evidence. The Journal of Finance, 43(2): 507–528.
Carhart, M. M. (1997). On Persistence in Mutual Fund Performance. Journal of Finance, 52(1): 57–82.
Chan, K. C., Hamao, Y. & Lakonishok, J. (1991). Fundamentals and Stock Returns in Japan. Journal of Finance, 46 (5): 1739–1789.
Chen, N.F. & Reymond, K. (1989). Expected returns and the bid-ask spread. Working paper, University of Chicago.
Chordia, T., Roll, R. & Subrahmanyam, A. (2000). Commonality in liquidity. Journal of Financial Economics, 56(1): 3–28.
Chui, A. & Wei, K. C. (1998). Book-to-Market, Firm Size and the Turn-of-the-Year Effect: Evidence from Pacific–Basin Emerging Markets. Pacific-Basin Finance Journal, 6 (3/4): 275–293.
Datar, V., Naik, N. & Radcliffe, R. (1998). Liquidity and asset returns: an alternative test. Journal of Financial Markets, 1(2): 203-220.
Easley, D., Hvidkjaer, S. & O’Hara, M. (2004). Factoring information into returns. Working Paper. Cornell University.
Eslami Bidgholi, GH. & Khojasteh, M.A. (2008). Improving portfolio performance based on risk adjusted return in capital productivity oriented investments. Journal of financial research, 9(4): 3-21. (in Persian)
Fama, E.F. & French, K.R. (1993). Common Risk Factors in the Returns on Stocks and Bonds. Journal of Financial Economics, 33 (1): 3-56.
Fama, E. F. (1998). Market efficiency, long-term returns, and behavioral finance. Journal of Financial Economics, 49(3): 283-306.
Fama, E. F. & French, K.R. (1996). Multifactor Explanations of Asset Pricing Anomalies, Journal of Finance, 51(1): 55–84.
Forooghi, D., Frahmand, SH. & Ebrahimi, M. (2011). The relation between liquidity and performance of firms listed at Tehran Stock Exchange. Journal of Securities and Exchange, 4(15): 125-143. (in Persian)
Foster, K.R. & Kharazi, A. (2008). Contrarian and Momentum Returns on Iran's Tehran Stock Exchange. The Journal of International Financial Markets, Institutions & Money, 18(1): 16-30.
Ghalibaf Asl, H. & Eghbali, E. (2013). Examining liquidity premium and two-factor model in Tehran Stock Exchange. Quantitative studies in management, 4(4): 1-22. (in Persian)
Ghalibaf Asl, H. & Izadi, M. (2014). The relation between risk and return in Tehran Stock Exchange: momentum effect and liquidity risk. Monetary and Financial Economy, New series, 21(7): 84-104. (in Persian)
Ghalibaf Asl, H. & Karimi, M. (2012). Pricing of liquidity, size, value, and market risk premiums in Tehran Stock Exchange. Journal of Securities and Exchange, 5(17): 85-105. (in Persian)
Ghalibaf Asl, H., Shams, Sh. & Sadehvand, M. J. (2010). Examining the abnormal returns on price and earnings momentum in Tehran Stock Exchange. The Iranian Accounting and Auditing Review, 17(61): 99-116. (in Persian)
Hashemi, S. A., Qajavand, Z. & Qajavand, S. (2013). The effects of different levels of liquidity measures on stock returns premium using a four-factor model. Journal of Finance and asset management. 1(2): 69-86.
(in Persian)
Herrera, M. J. & Lockwood, L. J. (1994). The Size Effect in the Mexican Stock Market. Journal of Banking and Finance, 18(4): 621-632.
Huberman, G. & Halka, D. (2001). Systematic liquidity. Journal of Financial Research, 24(2): 161–178.
Hubinette, N. & Jonsson, G. (2011). An Alternative Four-Factor Model. Master Thesis in Finance Stockholm School of Economics.
Jaff, J., Keim, D. B. & Westerfied, R.(1989). Earnings Yields, Market Values, and Stock Returns. Journal of Finance, 44(1): 135-348.
Jegadeesh, N. & Titman, S. (1993). Returns to buying winners and selling losers: implications for stock market efficiency. Journal of Finance, 48(1): 65–91.
L’Her, J., Masmoudi, T. & Suret, J. (2004). Evidence to Support the Four-Factor Pricing Model from the Canadian Stock Market. Journal of International Financial Markets, Institutions and Money, 14(4): 313–328.
Lam, K.S.K., Li, F.K. & & So, S.M.S. (2009). On the Validity of the Augmented Fama-French Four-Factor Model. University of Macau.
Lee, C., Swaminathan, B. (2000). Price momentum and trading volume. Journal of Finance, 55(5): 2017–2069.
Liew, J. &Vassalou, M. (2000). Can Book-to-Market, Size and Momentum be Risk Factors that Predict Economic Growth? Journal of Financial Economics, 57(2): 221–245.
Liu, W. (2006). A liquidity augmented capital asset pricing model. Journal of Financial Economics, 82 (3): 631–671.
Lustig, H. (2001). The market price of aggregate risk and the wealth distribution. Unpublished working paper, University of Chicago (NBER).
Mehrani, S. & Rasaeian, A. (2009). The relation between liquidity measures and annual stock returns in Tehran Stock Exchange. Journal of Accounting, 1(1):217-230. (in Persian)
Mojtahedzadeh, V. & Tarami, M. (2006). Examining Fama-French three- factor model in explaining stock returns in Tehran Stock Exchange. The message of Management. Nos. 17, 18: 109-132. (in Persian)
Newey, W. & West, K. (1987). A simple, positive semi-definite heteroskedasticity and autocorrelation consistent covariance matrix. Econometrica, 55(3): 703–708.
O’Brien, M., Brailsford, T. & Gaunt, C. (2010). Interaction of size, book-to-market and momentum effects in Australia. Accounting and Finance, 50(1): 197–219.
Pastor, L. & Stambaugh, R. (2003). Liquidity risk and expected stock returns. Journal of Political Economy, 111(3): 642–685.
Reinganum, M. R. (1981). Misspecification of Capital Asset Pricing: Empirical Anomalies based on Earnings’ Yields and Market Values. Journal of Financial Economics, 9(1): 19-46.
Reinganum, M. R. (1982). A Direct Test of Roll’s Conjecture on the Firm Size Effect. Journal of Finance, 37(1): 27–35.
Rosenberg, B., Reid, K. & Lanstein, R. (1985). Persuasive Evidence of Market Inefficiency. Journal of Portfolio Management, 11(3): 9–16.
Rostami, M. & Rezaee Moqaddam, A. (2013). A survey of long-term return on IPOs using Fama-French model, liquidity and leverage. Management researches in Iran. 17(3): 113-127. (in Persian)
Sadeqi Sharif, S. J., Talaneh, A. & Askari Rad, H. (2013). Momentum Factor Effect on the Explanatory Power of Fama-French Three-Factor Model: Evidence from Tehran Stock Exchange. Journal of accounting knowledge, 4(12): 59-88. (in Persian)
Sadka, R. (2006). Momentum and post-earnings-announcement drift anomalies: The role of liquidity risk. Journal of Financial Economics, 80(2): 309–349.
Yahyazadehfar, M. & Khoramdin, J. (2008). The role of liquidity factors and iliquidity risk in explaining stock returns in Tehran Stock Exchange. The Iranian Accounting and Auditing Review, 15(53): 101-118. (in Persian)
Yahyazadehfar, M., Shams, Sh. & Larimi, S. J. (2010). The relation between liquidity an stock returns in Tehran Stock Exchange. Journal of Financial Researches, 12 (29): 111-128. (in Persian)