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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 it significantly predicts 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 time 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 fully eliminated its impact.

Lubos Pastor,

2.37. Small trades and the cross-section of stock returns This paper uses volume arising from small trades to analyze the effect of retail investor trading behavior on the cross-section of stock returns. The central finding is that stocks with intense sell-initiated small-trade volume, measured over the past several months, outperform stocks with intense buy-initiated small-trade volume. This return difference accrues from the first month after the portfolio formation up to three years later. The results suggest that stocks favored by retail investors become overvalued and subsequently experience prolonged underperformance relative to stocks out of favor with retail investors. A literature has emerged which finds systematic trading behavior among various investor groups. For instance, individual investors are found to quickly realize gains, but refrain from realizing losses; mutual funds and other institutional investors tend to follow momentum strategies, while individuals tend to be short-term contrarians, but longer-term momentum traders; a strong seasonal component exists to individuals ’ trading behavior; trading frequency by individuals depends on gender; small and large investors respond differently to events such as earnings releases, seasoned equity offerings, and analysts ’ recommendations.

We find strong evidence that option trading volume contains information about future stock price movements. Taking advantage of a unique dataset from the Chicago Board Options Exchange, we construct put to call ratios for underlying stocks, using volume initiated by buyers to open new option positions. Performing daily crosssectional analyses from 1990 to 2001, we find that buying stocks with low put/call ratios and selling stocks with high put/call ratios generates an expected return of 40 basis points per day and 1 percent per week. This result is present during each year of our sample period, and is not affected by the exclusion of earnings announcement windows. Moreover, the result is stronger for smaller stocks, indicating more informed trading in options on stocks with less efficient information flow. Our analysis also sheds light on the type of investors behind the informed option trading. Specifically, we find that option trading from customers of full service brokers provides the strongest predictability, while that from firm proprietary traders is not informative. Finally, in contrast to the equity option market, we do not find any evidence of informed trading in the index option market.

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Recent research has shown that default risk accounts for only a part of the total yield spread on risky corporate bonds relative to their risk-less benchmarks. One candidate for the unexplained portion of the spread is a premium for liquidity. We investigate this possibility by relating the liquidity of corporate bonds, as measured by their ease of market access, to the basis between the credit default swap (CDS) price of the issuer and the par-equivalent corporate bond yield spread. The ease of access of a bond is measured using a recently developed measure called latent liquidity, which is defined as the weighted average turnover of funds holding the bond, where the weights are their fractional holdings of the bond. We find that bonds with higher latent liquidity are more expensive relative to their CDS contracts, after controlling for other realized measures of liquidity. Additionally, we document the positive effects of liquidity in the CDS market on the CDS-bond basis. We also find that several firm-level variables related to credit risk negatively affect the basis, indicating that the CDS price does not fully capture the credit risk of the bond. Furthermore, we find that when default risk of a firm is high, its illiquid bonds are more expensive. We also document that bond-level variables related to features of the contract that may be related to credit risk, such as the presence of covenants, have a negative impact on the

Schipper, two anonymous referees, and seminar participants at the Wharton School, and gratefully acknowledge the financial support of the Wharton School. Rodrigo Verdi is also grateful for financial In an influential recent empirical paper, Francis, LaFond, Olsson, and Schipper (FLOS, Journal of Accounting and Economics 2005) conclude that accruals quality (AQ) is a priced risk factor. Such a claim is important to understand given that there is no consensus in current theory that accounting quality or information risk is priced, and that more recent papers question earlier claims that information risk is not diversifiable. FLOS base their inference, in part, on results from time-series regressions of contemporaneous stock returns on returns to portfolios that mimic exposure to AQ, the market, size, and book-to-market. We show that FLOS ’ tests of a contemporaneous relation between excess returns and factor returns do not test the hypothesis that AQ is a priced risk factor. We conduct well-specified asset pricing tests for determining whether a potential risk factor explains expected returns, and find no evidence that AQ is a priced risk factor. While evidence from other types of tests, such as the implied cost-of-capital tests in Francis, LaFond, Olsson, and Schipper (The Accounting Review 2004), show that firms with higher accounting quality have lower implied cost-of-capital, it is important for researchers to know that traditional asset pricing tests provide no support for this hypothesis.

We investigate the pricing discount for limited liquidity. Unlike previous studies that have examined the relation between historical returns and liquidity, ours looks directly at current stock prices. This approach requires less data and yields up-todate information about limited liquidity discounts. We analyze data from the Swiss exchange and the Nasdaq during 1995–2001, and find a statistically and economically significant price-liquidity relation in both markets. We test the robustness of that relation with a procedure that does not rely on specific distributional assumptions. Our findings are unaffected. Accordingly, the discount suffered by the least liquid securities is about 30%.