The Effects of Liquidity on Stock Return by Controlling Investment Styles: New Approach with a Multidimensional Measure

Liquidity is a complex and multidimensional concept which affects investment decisions of investors in many ways. Liquidity, recently, has been widely considered as a return determinant, while neither the Capital Asset Pricing Model (CAPM) nor the Fama–French three factor model can account for the liquidity premium. This study aims to examine the effects of liquidity on stock return, using a combined approach to cover different dimensions of liquidity into a unit measure, with respect to the control role of investment styles effects. The analysis in this paper is carried out for ten portfolios, consisting common stocks of the companies listed in the Tehran Stock Exchange, using pooling data at monthly base from March 2002 to November 2011.
The results of regression analysis show that liquidity within the CAPM significantly affects excess return, and liquidity beta is larger than market beta, although both of them have high and significant effects. Also, findings indicate that liquidity is a priced factor even after controlling size, value and momentum styles; and four-factor model that includes market, liquidity, size and value factors is the best model to explain the excess return in Tehran Stock Exchange.