臺大管理論叢 NTU Management Review VOL.29 NO.1

The Illiquidity Premium: Further Evidence from Global and Asia-Pacific Markets 2 1. Introduction The basic tenet of asset pricing theories is that the expected return on equity is positively related to risk. Investors are averse to risk and hence demand larger premium for investing in riskier stocks. In these markets, securities with identical cash flows must have the same prices, reflecting the principle of the Law of One Price. These theories assume that stock trading is frictionless. However, in reality, the frictionless trading assumption rarely holds. Investors incur trading costs that rise when there is price impact that move prices. Stock illiquidity, which includes transaction costs and price impact of trading, is detrimental to investors as it reduces the net return after costs. Consequently, rational investors demand a higher expected return for investing in illiquid stocks. This is proposed by Amihud and Mendelson (1986). A great body of empirical work since then supports this proposition. 1 Transaction costs are mainly due to inventory cost and asymmetric information. When a seller initiates a trade, buyers in the market would suspect that the seller may have negative information about the stock. They will agree to buy but only at a discount (Copeland and Galai, 1983; Glosten and Milgrom, 1985; Kyle, 1985). Market makers who buy the stock worry about the risk of holding the stock given its risk and the limits on their resources and therefore buy at a discount and sell at a premium, which gives rise to a bid- ask spread (Stoll, 1978; Amihud and Mendelson, 1980; Ho and Stoll, 1981). Amihud and Mendelson (1986) propose that investors demand compensation for stock illiquidity. As a result, in equilibrium expected return is an increasing function of transaction costs. Evidence supporting this proposition is provided in Amihud and Mendelson (1986), Brennan and Subrahmanyam (1996), and Amihud (2002) for the US stock market. Recently, Amihud, Hameed, Kang, and Zhang (2015) present evidence of significant positive illiquidity return premium in global equity markets. Amihud et al. (2015) also show that there is a strong cross-country commonality in the illiquidity premium, which is different from commonality in illiquidity itself, found by Karolyi, Lee, and Van Dijk (2012). This study extends the work of Amihud et al. (2015) in two ways. We use a longer sample period, from January 1990 to June 2015, to calculate the illiquidity premium in international stock markets. We specifically estimate the illiquidity premium in 16 Asia- 1 For a review, see Amihud, Mendelson, and Pedersen (2006, 2012).