Liquidity commonality and pricing in UK equities

We investigate the pricing of systematic liquidity risk in UK equities using a large sample of daily data. Employing four alternative measures of liquidity we first find strong evidence of commonality in liquidity across stocks. We apply asymptotic principal component analysis (PCA) on the sample of stocks to extract market or systematic liquidity factors. Previous research on systematic liquidity risk, estimated using PCA, is focused on the US, which has very different market structures to the UK. Our pricing results indicate that systematic liquidity risk is positively priced in the cross-section of stocks, specifically for the quoted spread liquidity measure. These findings around the pricing of systematic liquidity risk are not affected by the level of individual stock liquidity as a risk characteristic. However, counter-intuitively, we find that the latter is negatively priced in the cross-section of stocks, confirming earlier research.

Using asymptotic principal component analysis common factors are extracted within each liquidity measure and across all four liquidity measures together. We denote these as market liquidity factors. The factors are then pre-whitened by an AR(2) process to capture shocks to market liquidity. The time series of the shocks are plotted for each measure and across all measures for the time period June 1991–December 2013.Figure optionsDownload as PowerPoint slide