Liquidity and Mispricing

Abstract

The expected return of a strategy that consists of buying underpriced stocks and shorting overpriced ones is substantially larger for illiquid stocks than for liquid ones. This premium can be attributed to the short leg among illiquid stocks, driven by arbitrage asymmetry. The latter effect is also reflected in a univariate sort based on liquidity: a negative premium occurs, contrary to popular beliefs, driven by overpricing among illiquid stocks and underpricing among liquid ones. Furthermore, negative liquidity shocks increase overpricing, whereas positive shocks increase underpricing. These results emphasize the important role of liquidity in explaining the cross-section of expected stock returns.