Illiquidity Shocks and Asymmetric Stock Market Reactions Around the World: Is Underreaction or Illiquidity Spiral the Culprit?

Illiquidity shocks are negatively associated with future returns. There are two potential explanations: underreaction and illiquidity spiral. We find that negative illiquidity shocks generate upward price continuation, but positive illiquidity shocks lead to initial downward price continuation quickly followed by price reversal. Further analysis shows that the underreaction channel works well only in stocks with negative illiquidity shocks, whereas the illiquidity spiral channel is strongly supported in stocks with positive illiquidity shocks. Moreover, our results are not subsumed by the numerator component (i.e., volatility shocks) or denominator component (i.e., volatility shocks) of the illiquidity shocks.