Academic journal article Economics, Management and Financial Markets

The Impact of Liquidity on the Cross Section of Equity Returns on the Johannesburg Securities Exchange

Academic journal article Economics, Management and Financial Markets

The Impact of Liquidity on the Cross Section of Equity Returns on the Johannesburg Securities Exchange

Article excerpt

(ProQuest: ... denotes formulae omitted.)

1. Introduction

A vast amount of literature regarding capital market efficiency is promptly available to investors and researchers. According to Brown and Reilly (2009: 156), the most widely used techniques in reaching conclusions with regards to market efficiency include statistical tests of independence between rates of return, applications of technical trading rules (specifically, comparing risk - return results for trading rules based on past market information to a simple buy-and-hold strategy), predicting future returns using available public information and studies examining how quick stock prices adjust to significant economic events, referred to as "event studies." The findings of these studies are not unanimous, resulting in support for and against capital market efficiency. A number of researchers that oppose market efficiency have shown that certain firm-specific factors are highly significant in explaining the cross section of equity returns and that these factors can be used in the investment decision making process to obtain sustainable significant abnormal returns. Proponents of market efficiency though suggest that there are important market considerations that should be taken into account in order for these factors to be regarded as market anomalies (rather than common risk factors) and that these consid erations are regularly ignored in empirical studies. One such consideration is market liquidity. This article attempts to determine whether market liquidity does indeed h ave an effect on the identity and explanatory power of factors that explain the cross section of equity returns on the Johannesburg Securities Exchange (JSE).

The rest of the article is structured as follows: Section 2 provides a short overview of prior related research followed by a discussion on the data used and methods applied in conducting the research in Section 3. The results are presented in Section 4 and Section 5 concludes the article.

2. Literature Review

To reach the current study's objective, it is first necessary to identify and include as many firm-specific factors that could potentially contribute significantly to explaining the cross section of equity returns as possible. Once potential factors have been identified, a liquidity filter is introduced and the cross section of returns are re-examined to determine the impact liquidity may have on the identity and explanatory power of these firm-specific factors.

As a first step to identify the factors to be considered for inclusion, related literature concerning the techniques most commonly applied to test market efficiency as suggested by Brown and Reilly (2009: 156), namely independence between returns, technical trading rules and return prediction based on fundamentals were reviewed. A brief summary is provided here.

The first two techniques, independence between returns and technical trading rules, mostly involve studies of serial (or auto) correlation. Specifically, positive serial correlation is classified as price momentum (i.e. price increases (decreases) are followed by more price increases (decreases)) while negative serial correlation is classified as price reversal (i.e. price increases (decreases) are followed by price decreases (increases)). Earlier studies (see for example Kendall & Hill, 1953; Granger & Morgenstern, 1963; Godfrey, Granger & Morgenstern, 1964; Fama, 1965; Fama, 1970), found no evidence of significant serial correlation between lagged price changes or returns. These authors concluded that technical trading rules cannot be used to create portfolios that may offer significant abnormal returns. Later studies (De Bondt & Thaler, 1985; Summers, 1986; Fama & French, 1988; Lo & Mackinley, 1988; Jegadeesh, 1990; Jegadeesh & Titman, 1993; Chan, Hameed & Tong, 2000; Avramov & Chordia, 2006; Boynton & Oppenheimer, 2006; Lewellen & Nagel, 2006, Gutierrez & Pirinsky, 2007; Blitz, Huij & Martens, 2011, Han, Zhou & Zhu, 2014) however suggest that momentum factors and price reversal factors may contribute significantly to explaining equity returns and can be used to obtain considerable abnormal returns. …

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