| Abstract: |
Given the cross-sectional and temporal variation in their liquidity, emerging
equity markets provide an ideal setting to examine the impact of liquidity on
expected returns. Our main liquidity measure is a transformation of the
proportion of zero daily firm returns, averaged over the month. We find that
our liquidity measures significantly predict future returns, whereas
alternative measures such as turnover do not. Consistent with liquidity being
a priced factor, unexpected liquidity shocks are positively correlated with
contemporaneous return shocks and negatively correlated with shocks to the
dividend yield. We consider a simple asset pricing model with liquidity and
the market portfolio as risk factors and transaction costs that are
proportional to liquidity. The model differentiates between integrated and
segmented countries and periods. Our results suggest that local market
liquidity is an important driver of expected returns in emerging markets, and
that the liberalization process has not eliminated its impact. |