The Role of Liquidity Risk in Asset Pricing: Evidence from Sri Lanka

Abstract

Securities liquidity varies over time, which leads to equity return volatility. It implies that the liquidity in the capital markets is a significant source of risk. Therefore, liquidity risk in securities is difficult to diversify and contributes to the systemic market risk. This study aims to analyze the relationship between securities returns and liquidity risk while taking into account the time-varying characteristics of illiquidity on the Colombo Stock Exchange from 2015-2019 and taking into account the effect of liquidity level, using the Generalized Method of Movements (GMM) framework model to assess the persistence of illiquidity securities contributions of the updated version of the Amihud illiquidity (Amihud, 1986) proxy to represent across time market illiquidity and to research the time-series relationship between liquidity and returns. The pricing of liquidity risk and its implications for expected returns are empirically tested using the conditional liquidity adjusted capital asset pricing model (LCAPM), where stock returns are cross-sectionally dependent on market risk and three additional betas (β¹, β² , β³ ) that capture different aspects of illiquidity and its risk. The findings reveal some support for the conditional capital asset pricing model (CAPM), but results are not robust to alternative specifications and estimation techniques. The total effect of liquidity risk is 0.11%, and illiquidity is 2.5% per year. Illiquidity premium depends on the expected transaction cost at the end of the holding period for investors' 2.5%. This makes the overall illiquidity premium of 2.61%. These estimates and the overall importance of liquidity level and liquidity risk depend on the model implied restrictions of a constant market risk premium and a fixed transaction cost. However, LCAPM has constructed conditionally; it can relax these model-implied constraints and estimate different liquidity risk premiums while also allowing transaction costs to be a free parameter. The overall liquidity risk characterized by liquidity betas with a single market risk premium is relatively small and barely significant in the restricted model. Using this unrestricted model, find that the overall illiquidity premium corresponds to 2.61%. The empirical results shed light on these channels' toal and relative economic significance and provide evidence of flight to liquidity.

Keywords: Capital Asset Pricing Model, Liquidity Risk, Liquidity beta, Generalize Method of Movement, Sri Lanka