Systematic liquidity risk and stock price reaction to shocks

Authors


  • The authors would like to thank Dr Peter Prowse for his comments and Dr Panagiotis Andrikopoulos and Mr Ali Ferda Arikan for their research support. The paper has also benefited immensely from the comments of an anonymous referee and the editor Prof. Robert Faff.

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.

Ancillary