Liquidity in Stock Markets

Abstract

This thesis uses liquidity to examine some stock market phenomena. It begins by researching the role of liquidity in explaining the “disappearing dividend puzzle” across several financial markets. Then, it examines the cash/stock dividend payouts and their determinants in China. Finally, this paper investigates the interplay among illiquidity, variance risk premium and stock market returns.

The research studies the disappearing dividend puzzle with a large sample of firms representing eighteen countries over the sample period from 1989 to 2011. Our investigation finds that risk is an important determinant of firms’ dividend payout policy. For firms in the US, France, UK and other European markets, liquidity plays an additional role in explaining the changes in propensity to pay. Then we test the explanatory power of liquidity, risk and catering incentives in the “disappearing dividend puzzle”. The thesis finds support for catering theory among firms in common law countries but not those in civil law countries. The catering incentives persist even after adjusting the propensity to pay for liquidity. However, after controlling for risk, the significant explanatory power of catering incentives in the changes in propensity to pay disappears. Our results indicate that catering incentives capture the risk difference between dividend payers and non-dividend payers.

Then, the research studies the payout patterns of both cash and stock dividend in China over the sample period 1999-2013. The Chinese stock market is a fast-growing market with some special characteristics, such as complicated corporate ownership structures. The specific characteristics of Chinese firms might affect the dividend payout policy in China. We first study the determinants of Chinese firms’ dividend payout policy. Our results indicate that lifecycle, risk and liquidity are important determinants of firms’ cash/stock dividend policy. We find that firms with larger board size and fewer annual board meetings are more likely to pay cash dividends and less likely to pay stock dividends. Also, the research notes that managerial stake is insignificant in explaining Chinese firms’ cash/stock dividend payouts. Then, we investigate the catering theory in China. Our findings show that catering incentives matter in explaining the unexpected percentage of dividend payers if we do not control for liquidity/risk. However, once we control for liquidity/risk, the catering incentives contribute little toward explaining the changes in propensity to pay cash/stock dividends. Our results imply that Chinese firms’ cash/stock dividend policy is influenced by the board, rather than managers or investors.

Finally, this thesis investigates the interplay among illiquidity, variance risk premium and market returns. Previous studies that test whether liquidity is useful in forecasting market returns ignore the question of whether variance risk premium might also be useful for this purpose. As a result, these papers potentially overestimate the role of liquidity in predicting market returns. This thesis tests whether liquidity and variance risk premium are useful for return forecasting by comprehensively investigating the interplay among illiquidity, variance risk premium and market returns. We adopt monthly US data from January 1992 to December 2010. The results show that variance risk premium, reflecting investors’ risk aversion to volatility risk, causes variations in stock returns, and in turn causes market illiquidity, rather than vice versa. Furthermore, we find that variance risk premium has substantial forecasting power over future market returns, while liquidity measure does not. Additionally, our results indicate that variance risk premium impacts equity returns by acting on the risk factors, i.e. market risk premium, value factor and momentum factor.