Systematic liquidity risk and stock price reaction to shocks

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Abstract:

Abstract

This study examines the relationship between systematic liquidity risk and stock price reaction to large 1‐day price changes (or shocks). We base our analysis on a yearly updated constituents list of the FTSE All share index. Our overall results are consistent with the price continuation hypothesis, which suggests that positive (negative) shocks will be followed by positive (negative) abnormal returns. However, further analysis indicates that stocks with low systematic liquidity risk react efficiently to both positive and negative shocks, whereas stocks with high systematic liquidity risk underreact to both positive and negative shocks. Our results are valid irrespective of various robustness tests such as size of the shock, size of the firm, month‐of‐the‐year and day‐of‐the‐week effects. We conclude that trading on price patterns following shocks may not be profitable, as it involves taking substantial liquidity exposure.

Document Type: Research Article

DOI: http://dx.doi.org/10.1111/j.1467-629X.2011.00403.x

Affiliations: 1: Bradford University School of Management, Emm Lane, Bradford, BD9 4JL, UK 2: Department of Finance and Banking, Yarmouk University, PO Box 566, 21163, Irbid, Jordan 3: Sheffield Business School, University of Sheffield, Western Bank, Sheffield, S10 2TN, UK

Publication date: June 1, 2012

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