Stock Liquidity and Investment Opportunities: Evidence from Index Additions

Authors


  • The authors thank an anonymous referee, Bill Christie (the Editor), Jennifer Bethel, Jeff Brookman, John Chalmers, Diane Del Guercio, Michael Goldstein, Jarrad Harford, Laurie Krigman, Rick Sias, Erik Sirri, and seminar participants at Washington State University for their helpful comments and suggestions. The authors were formerly at the University of New Hampshire and Babson College, respectively.

Abstract

We examine the relation between stock liquidity and investment opportunities in a sample of firms experiencing an exogenous liquidity shock. We find a positive relation between changes in capital expenditures and changes in stock liquidity, indicating that stock liquidity influences corporate investment decisions. This relation is robust to alternative measures of growth opportunities, and is consistent with a liquidity premium in equity returns. That is, an increase in liquidity effectively expands the set of positive NPV projects because it reduces the cost of capital. The results suggest that liquidity-enhancing events benefit shareholders by increasing the pool of viable growth opportunities.

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