Research on the premium for the joint lower-tail risk of liquidity and investor sentiment

Abstract

Considering the dual risks of extreme downside liquidity and extreme negative sentiment, we introduce the concept of the joint lower-tail risk of liquidity and investor sentiment (LISR) and construct measures to study the issue of lower-tail risk premiums in the Chinese stock market. Our findings provide convincing evidence that the premiums for LISR measures are significant regardless of the sentiment at the market or firm level. Downside liquidity risk and extreme negative sentiment cannot explain the LISR premiums separately, which means that an extreme downside change in liquidity and extreme negative sentiment have a joint effect on future stock returns. In addition, LISR premiums are robust to various portfolio double sorts, hold for various asset pricing factor models and remain significant when controlling for an extensive list of firm characteristics. Our conclusions have obvious value for improving and enriching the theoretical research on investor sentiment and liquidity risk premiums, and they provide a valuable reference for investors aiming to construct portfolios matching their own risk preferences, and for regulators supervising the market.