Idiosyncratic risk, returns and liquidity in the London Stock Exchange: A spillover approach

Recent evidence has shown that liquidity and idiosyncratic risk may be priced factors in the cross section of expected stock returns and that market capitalization significantly affects investor behavior and liquidity. We explore the interactions between liquidity, idiosyncratic risk and return across time as well as across size-based portfolios of stocks listed in the London Stock Exchange. We find that volatility spills over from large to small-cap stocks and vice versa and is predicted by illiquidity shocks in both small and large-cap portfolios. Illiquidity is forecasted by return shocks in small-cap stocks. Finally, we document some evidence of asymmetric liquidity spillovers, supporting the intuition that market-wide information is first incorporated in the trading behavior of large-cap investors and is then transmitted in the trading of small stocks.