Liquidity Risk and Cross-Sectional Earnings-Returns Relation

Abstract

Employing a broad sample of US firms over the period 1962 to 2009, we provide evidence of a liquidity risk impact on the fundamental earnings-returns relation. Specifically, we document that current liquidity risk has a positive moderating effect on the relation between current returns and next period change in earnings. Notably, this effect is distinct from (and after controlling for) the negative effect observed for illiquidity level (Kerr, Sadka and Sadka, 2012). We further show that the liquidity risk effect on the earnings-returns relation is dominant in firms that: (a) are of intermediate size; (b) are of intermediate book-to-market; and (c) are profitable.