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Market Illiquidity and Conditional Equity PremiumAuthor(s): Hui Guo, Sandra Mortal, Robert Savickas, Robert Wood
Publication Name: Financial Management, Page Number(s): 24
We examine the time-series relation between aggregate bid-ask spreads and conditional equity premium. We document that average marketwide relative effective bid-ask spreads forecast aggre- gate market returns only when controlling for average idiosyncratic variance. This control allows us to document the otherwise elusive relation between illiquidity and returns. The reason is that idiosyncratic variance correlates positively with spreads but has a negative effect on conditional equity premium, causing an omitted variable bias. Our results are robust to standard return pre- dictors, alternative illiquidity measures, and out-of-sample tests. These findings are important because they provide strong support for the literature’s conjecture that marketwide liquidity is an important asset pricing risk factor.