| Abstract: |
In the light of recent evidence that liquidity and idiosyncratic risk may be
priced factors in the cross section of expected stock returns and that market
capitalization significantly affects investor behavior and liquidity, we
explore the interactions between liquidity, idiosyncratic risk and return
across time as well as across size-based portfolios of stocks listed in the
London Stock Exchange. In a Vector Autoregressive (VAR) analytical framework,
we find that volatility spills over from large cap stocks to small cap stocks
and vice versa. Volatility shocks can be predicted by illiquidity shocks in
both large cap as well as in the small cap portfolios. Illiquidity can be
predicted by return shocks in small cap stocks. Finally, we document some
evidence of asymmetric liquidity spillovers, from large cap stocks to small
cap ones, supporting the intuition that common information is first
incorporated in the trading behavior of large-cap investors and the liquidity
of large cap stocks and is then transmitted in the trading of small stocks. |