Illiquidity and stock returns: Italian evidence

This study investigates the cross section and time series relationship between stock return and illiquidity in the Italian Stock Exchange, following the models suggested by Amihud in 2002.
The cross-sectional model is tested employing several liquidity/illiquidity measures to allow comparisons with finer and better measures, such as the bid-ask spread, and simpler and rougher measures, such as the Amihud illiquidity measure.
Since Amihud illiquidity and other measures vary considerable over the months, they are also replaced in the estimation of the proposed model by their mean-adjusted value, which is the monthly ratio of the considered measure to its average across stocks in each month.
The relation between illiquidity and stock return is also examined over time. The hypothesis is that over time, the ex ante stock excess return is increasing in the expected illiquidity of the stock market. Results are consistent with the hypothesis and with findings of Amihud (2002), showing that expected stock excess return reflects compensation for expected market illiquidity.
In the latter part of the analysis the evolution over time of market change in illiquidity and the systematic liquidity are examined. The findings are consistent with those of Kamara et al. (2008) which do not note a particular time trend in the market illiquidity variation. Furthermore the sensitivity of changes in the liquidity of stock to changes in aggregate liquidity (the liquidity beta) has a positive and highly significant effect on the liquidity of the single stock.
A further insight we provide regards the flight to liquidity. Examining the distribution of the monthly market share in each cap-quintile of our sample, we can note the presence of the flight to liquidity phenomenon, during turbulent times.
The paper is organized as follows. Section 1 proposes a general survey on liquidity. Section 2 provides a brief summary of the main empirical evidence on the return-illiquidity relationship. Section 3 describes the data, the methodology used, the tests and the results. Section 4 presents conclusion remarks and implications.