Illiquidity, Financial Distress, and Stock Returns

Over the past decade, six proxies have been put forward in the finance literature to assert the impact of illiquidity risk on expected returns, i.e. Amihud (2002), Pastor and Stambaugh (2003), Acharya and Petersen (2005), Liu (2006), Sadka (2006), and Chordia, Huh, Subrahmanyam (2009). A positive relation between these proxies and subsequent returns is presented by these studies as evidence in support of the illiquidity risk compensation argument. However, what all these proxies have in common is that they are derived from observable trading activity variables, which are correlated with trading volume. Trading volume, which also captures investor sentiment, and stock prices are simultaneously determined by investor demand. To the extent that these empirically derived illiquidity risk proxies are correlated with trading volume, they cannot be exogenous to the process that generate stock returns. In this paper, we test whether the association of illiquidity risk proxies and stock returns are indeed compensation for bearing illiquidity risk or instead are manifestation of mispricing effects. We show that the return premia associated with these six proxies are difficult to reconcile with illiquidity risk compensation explanation. First, among stocks assumed by all six proxies to bear higher (lower) illiquidity risk, we observe that the higher (lower) abnormal returns are more pronounced among those firms that are less (more) financially distressed; contrary to what a risk argument would predict. Second, stocks that are neutral in distress but have significant illiquidity spreads are unrelated to future abnormal returns. These results are robust and consistent across portfolios sorted by turnover or the six proxies. Our evidence suggests that the return premia associated with all six illiquidity risk proxies are confounded by mispricing effects related to financial distress. In other words, they overstate the contribution of illiquidity risk to expected returns.