Liquidity and stock returns: An alternative test

Author(s): Vinay T. Datar, Narayan Y. Naik, Robert Radcliffe

Abstract: This paper provides an alternative test of Amihud and Mendelson's (1986, Journal of Financial Economics, 8, 31D35) model using the turnover rate (number of shares traded as a fraction of the number of shares outstanding) as a proxy for liquidity. The evidence suggests that liquidity plays a signiTcant role in explaining the cross-sectional variation in stock returns. This e¤ect persists after controlling for the well known determinants of stock returns like the Trm-size, book-to-market ratio and the Trm beta. Unlike Eleswarapu and Reinganum (1993, Journal of Financial Economics, 34, 373D386), this paper Tnds that the liquidity e¤ect is not restricted to the month of January alone and is prevalent throughout the year. The evidence supports Amihud and Mendelson's (1986) notion of liquidity premium and establishes its role in the overall cross section of stock returns. 

Datar et al 1998 JFM.pdf