Liquidity: effect on securities returns in Indian capital markets

Abstract

In the mainstream literature of finance, Liquidity of an asset has not been considered an important determinant of its expected return or its price. There have been, however, few empirical and theoretical works which point out that liquidity of an asset determines its price (or expected returns). The issue is primarily empirical. Liquidity of an asset, here, has been defined in terms of transaction costs. The dissertation work undertaken is motivated by two research questions- a) whether liquidity of an asset affects its prices or expected returns?, and b) which types or transaction costs are relevant in Indian context? The second question presupposes affirmative answer to the first. The features of Indian capital market provide some events around which the liquidity of an asset gets affected systematically. Using event-study methodology, following three events were studied. i) Impact of decision by stock exchange authorities to shift some securities from "cash" group to "specified" group on those securities’ prices. ii) Impact on securities’ prices on ex-right day. iii) Impact on securities ‘prices on ex-bonus day. The results from these studies support the hypothesis that higher liquidity of an asset is priced. The Indian capital markets also expect higher returns for bearing illiquidity when the illiquidity is due to loss of opportunity to sell an asset. There is evidence of self-selection bias in the choice or estimation period/securities. The CAR (cumulative average residuals) computed on the basis of market model consequently show abnormal negative performance in the post-event period. The use of "market adjusted returns" instead of "market and risk adjusted returns“ results in well-behaved CARs and the price increases seem to be permanent strengthening the results. In the ex-bonus study, one anomaly with respect to “efficient-market hypothesis" was noticed, The market provides an opportunity to earn arbitrage profits by buying cum-bonus and selling ex-bonus specified group of shares. In case of first of these studies, it was found that there is no change in returns volatility after the securities are shifted to specified group. The prices of convertible debentures (those which have well-specified conversion terms) were also studied. It was found that convertible debentures are underpriced and the under pricing seems to be caused by the illiquidity faced by the investors around conversion date. The results, by and large, provide evidence that liquidity of an asset is an important determinant of its price or expected returns. This has important implications for corporate finance managers, investment/ portfolio managers, policy-makers and those in academics.