Seeking alpha

Abstract

This study examines the effect of liquidity and volatility in the stock returns in the Indian markets and hence, the relevance of these factors in taking security selection decision. In the studies on these parameters done all over the world, it has been found that illiquid stocks claim higher returns than the liquid stocks. Similarly, stocks with lower volatility claim higher returns than those having high volatility. This study seeks to understand the relevance of these factors in India. In case of volatility, we considered the standard deviation of the stock returns to be a proxy for the volatility of the stock. We sorted the stocks in the order of their volatility and constructed portfolios of high volatility and low volatility stocks. Empirical results showed the investing in low volatility stocks results in higher returns for the investors even in the Indian markets. For testing for liquidity, we measured liquidity using three prevalent parameters and arrived at a proxy measure of liquidity through Principal Component Analysis (PCA). Thereafter, we constructed portfolios of the high liquidity and low liquidity stocks and compared their returns. The results again showed that the liquidity factor too is very relevant in the Indian context. A regression run on the stock returns derived from investing in illiquid or low volatility stocks shows a positive alpha.