SSRN Id2055472

Liquidity Shocks and Stock Market Reactions
Turan G. Bali∗ Lin Peng† Yannan Shen‡ Yi Tang§

Georgetown University Baruch College Baruch College Fordham University
Abstract
We find that the stock market underreacts to stock level liquidity shocks: liquidity shocks
are not only positively associated with contemporaneous returns, but they also predict fu-
ture return continuations for up to six months. Long-short portfolios sorted on liquidity
shocks generate significant returns of 0.70% to 1.20% per month that are robust across
alternative shock measures and after controlling for risk factors and stock characteristics.
Furthermore, we show that investor inattention and illiquidity contribute to the underreac-
tion: while both are significant in explaining short-term return predictability of liquidity
shocks, the inattention-based mechanism is more powerful for the longer-term return pre-
dictability.
This draft: August 23, 2013
JEL classification code: G02, G10, G11, G12, G14, C13.

Keywords: Stock returns, liquidity shocks, stock market reactions, underreaction, investor attention.
∗ McDonough School of Business, Georgetown University, Washington, D.C. 20057. Email: tgb27@georgetown.edu. Phone: (202)
687-5388. Fax: (202) 687-4031.

† Department of Economics and Finance, Zicklin School of Business, Baruch College / CUNY, One Bernard Baruch Way, 10-225, New
York, NY 10010. Email: lin.peng@baruch.cuny.edu. Phone: (646) 312-3491. Fax: (646) 312-3451.
‡ Department of Accounting, Zicklin School of Business, Baruch College / CUNY, One Bernard Baruch Way, 12-225, New York, NY
10010. Email: yannan.shen@baruch.cuny.edu. Phone: (646) 312-3242. Fax: (646) 312-3161.

§ Schools of Business, Fordham University, 1790 Broadway, New York, NY 10019. Email: ytang@fordham.edu. Phone: (646) 312-8292.
Fax: (646) 312-8295.

We owe a great debt to David Hirshleifer and two anonymous referees for their extremely helpful comments and suggestions. We thank
Yakov Amihud, Andrew Ang, Tarun Chordia, Phil Dybvig, Pete Kyle, Jennifer Huang, Juan Londono, Robert Schwartz, Siew Hong Teoh,
Sheriden Titman, Robert Whitelaw, Wei Xiong and Jianfeng Yu for their insightful comments. We also benefited from discussions with Reena
Aggarwal, Linda Allen, Jim Angel, Bill Baber, Jim Bicksler, Henry Cao, Preeti Choudhary, Sandeep Dahiya, Ozgur Demirtas, Allan Eberhart,
Pengjie Gao, Gang Xiao, Olesya Grishchenko, Bin Han, Armen Hovakemian, Levent Guntay, Prem Jain, Soon-Ho Kim, Paul Kupiec, Yan
Li, Yuanzhi Li, Lalitha Naveen, George Panayotov, Lee Pinkowitz, Valery Polkovnichenko, Oleg Rytchkov, Mark Seasholes, Tugkan Tuzun,
Haluk Unal, Tan Wang, Yuan Wang, Bin Wei, Rohan Williamson, Liyan Yang, Harold Zhang, Xiaoyan Zhang, An Yan, Jialin Yu, Yuzhao
Zhang, Hao Zhou, and seminar participants at Baruch College, Beijing University, the Federal Deposit Insurance Corporation (FDIC),
the Federal Reserve Board, Georgetown University, Southwestern University of Finance and Economics, Temple University, Villanova
University, 2012 Liquidity Risk Management Conference of Fordham University, 2012 FMA Conference, 2012 Deutsche Bank Global Quant
Conference, 2012 The Chinese Finance Association Best Paper Symposium, 2012 State Street Quant Forum, 2013 Triple Crown Conference,
2013 China International Conference in Finance, National University of Singapore seventh Annual Risk Management Conference, and 2013
Summer Institute of Finance. Turan Bali thanks the Research Foundation of McDonough School of Business, Georgetown University.
Lin Peng thanks the PSC-CUNY Research Foundation and Wasserman Endownment BCF for financial support. All errors remain our
responsibility.
Electronic copy available at: https://ssrn.com/abstract=2055472

Abstract
We find that the stock market underreacts to stock level liquidity shocks: liquidity shocks
are not only positively associated with contemporaneous returns, but they also predict fu-
ture return continuations for up to six months. Long-short portfolios sorted on liquidity
shocks generate significant returns of 0.70% to 1.20% per month that are robust across
alternative shock measures and after controlling for risk factors and stock characteristics.
Furthermore, we show that investor inattention and illiquidity contribute to the underreac-
tion: while both are significant in explaining short-term return predictability of liquidity
shocks, the inattention-based mechanism is more powerful for the longer-term return pre-
dictability.
JEL classification code: G02, G10, G11, G12, G14, C13.
Keywords: Stock returns, liquidity shocks, stock market reactions, underreaction, investor attention.

1. Introduction
The liquidity of a stock refers to the degree to which a significant quantity can be traded within a short
time frame without incurring a large transaction cost or adverse price impact. It is well documented
that the level of individual stock illiquidity is positively priced in the cross-section of expected stock
returns.1 Amihud and Mendelson (1986) first propose this hypothesis and argue that investors demand
a premium for less liquid stocks, so that less liquid stocks should have higher average returns.2
Liquidity is also time-varying, and subject to shocks that have persistent effects (i.e., negative liq-
uidity shocks predict lower future liquidity).3 The most recent financial crisis and the heightened focus
on liquidity during the crisis show the importance of considering the effect of liquidity shocks on stock
returns. Given the documented positive relation between stock level illiquidity and expected returns,
a persistent negative shock to a security’s liquidity should result in low contemporaneous returns and
high future returns, and vice versa, if the effect of shock is immediately incorporated into security
prices. This has been argued by Amihud (2002), Jones (2002), and Acharya and Pedersen (2005),
among others.
However, the above prediction of a negative relation between liquidity shocks and future returns
may not hold in a market in which information is not fully reflected into prices due to market frictions.
Thus, studying market reactions to liquidity shocks can generate important insights on how the market
processes information about liquidity shocks and on the information efficiency of financial markets.
There are two potential market frictions that prevent public information from being incorporated
in security prices: limited investor attention and illiquidity. There has been an increasing body of em-
pirical evidence suggesting that investor inattention can lead to underreaction to information. These
1 See, among others, Amihud and Mendelson (1986, 1989), Brennan and Subrahmanyam (1996), Eleswarapu (1997),
Brennan, Chordia, and Subrahmanyam (1998), Datar, Naik, and Radcliffe (1998), Amihud (2002), and Hasbrouck (2009).
2 Theoretical studies that investigate the relation between liquidity and asset prices include Amihud and Mendelson (1986),
Constantinides (1986), Heaton and Lucas (1996), Vayanos (1998), Duffie, Garleanu, and Pedersen (2000, 2003), Huang
(2003), Garleanu and Pedersen (2004), and Lo, Mamaysky, and Wang (2004), among others.
3 See, for example, Amihud (2002), Chordia, Roll, and Subrahmanyam (2000, 2001), Hasbrouck and Seppi (2001), Hu-
berman and Halka (2001), Jones (2002), and Pastor and Stambaugh (2003).

studies show that, due to limited investor attention, stock prices underreact to public information about
stock fundamentals, such as new products, earnings news, demographic information, innovative effi-
ciency, or information about related stocks (e.g., Huberman and Regev (2001), Hirshleifer, Hou, Teoh,
and Zhang (2004), Hou and Moskowitz (2005), Hirshleifer, Lim, and Teoh (2009), Hong, Torous, and
Valkanov (2007), DellaVigna and Pollet (2007, 2009), Barber and Odean (2008), Cohen and Frazzini
(2008), and Hirshleifer, Hsu, and Li (2012)).
This paper focuses on liquidity shocks, which can be viewed as a type of public information on liq-
uidity.4 Compared to the direct and well-defined information events studied in the previous literature,
liquidity shocks are not well-defined and their pricing implications are harder to interpret by average
investors. As argued by Hirshleifer, Hsu, and Li (2012), investors would “have greater difficulty pro-
cessing information that is less tangible”, the indirect and illusive nature of liquidity news thus makes
the investors’ attention constraints more likely to be binding. As a result, stock market can under-react
to liquidity shocks. Moreover, as argued in the model of Peng and Xiong (2006), an investor who op-
timizes the amount of attention allocation would allocate more attention to systematic shocks and less
to or even completely ignore stock-specific shocks. Thus, a strong case can be made for underreaction
to stock level liquidity shocks based on theories of investor attention. Alternatively, when a stock is
harder to trade due to its illiquidity, price discovery can be delayed, resulting in slow price adjustments
following liquidity shocks.
To investigate how the stock market reacts to stock level liquidity shocks, we first examine the
immediate effect of liquidity shocks and find that it is positive and significantly related to contempo-
raneous stock returns. However, in terms of the relation between liquidity shocks and future returns,
contrary to the negative relation as one would expect in a full, informationally efficient setting, we
find the relation continues to be positive and highly significant. Depending on the proxy for liquidity
shock, decile portfolios that are long in stocks with positive liquidity shocks and short in stocks with
4 Liquidity shocks can be triggered by public information releases such as earnings announcements, company events such
as stock splits and share buy backs, the return performance of stocks, sensitivity of stocks to changes in market liquidity, or
due to concerns about trading against informed traders in times of heightened uncertainty.

negative liquidity shocks generate a one-month ahead raw and risk-adjusted returns of 0.75% to 1.23%
per month for equal-weighted portfolios, and 0.67% to 1.17% for value-weighted portfolios. The pre-
dictive power of liquidity shocks on future returns remains economically and statistically significant
for up to six months.
This evidence suggests that the market underreacts to stock level liquidity shocks. Although nega-
tive and persistent liquidity shocks do result in decreases in stock prices due to a higher future liquidity
risk premium, the prices adjustment is not complete within the same month. As a result, there is a con-
siderable amount of continuation of negative returns and the effects of shocks are not fully incorporated
into prices until months later. The opposite is true for positive liquidity shocks.
We further investigate the underlying mechanisms that may contribute to the underreaction to liq-
uidity shocks. The investor attention theory predicts that the degree of underreaction to liquidity shocks,
as measured by its return predictability, should be more pronounced for stocks that receive less investor
attention. On the other hand, the illiquidity-based mechanism predicts that the positive return pre-
dictability of liquidity shocks should be stronger for the less liquid stocks.
We divide our sample into subgroups based on investor attention proxies and illiquidity and find
that the positive link between liquidity shocks and future stock returns is indeed stronger for stocks that
receive less attention (small stocks, stocks with low analyst coverage and institutional ownership), as
well as for less liquid stocks. To gauge the relative importance of the attention- versus the illiquidity-
based mechanisms for underreaction, we perform Fama-MacBeth regression analysis and include both
attention proxies and illiquidity as interaction variables to liquidity shocks. We find that both the
attention proxies and illiquidity help explain the cross-sectional return predictability of liquidity shocks.
While both mechanisms are significant for one-month ahead return prediction, the inattention-based
mechanism is more powerful in predicting two- to four-month ahead returns. Our results thus suggest
that both investor inattention and illiquidity can drive stock market underreactions to liquidity shocks,
but investor attention is a more dominant factor compared to illiquidity.

Our results are based on three measures of liquidity shocks. The first is the negative difference
between Amihud’s (Amihud (2002)) illiquidity measure and its past 12-month mean.5 In addition
to this simple, nonparametric measure, we use a parametric methodology to construct a conditional
measure of liquidity shocks using an ARMA(1,1) specification for Amihud’s illiquidity.
One might argue that innovations in the Amihud’s illiquidity measure may be driven by news
announcements, i.e., the market makers update prices upon news without much trading, rather than
real changes in liquidity. To account for this possibility and ensure that our results are robust, we also
use an alternative measure of liquidity shocks based on the changes in bid-ask spreads. The results are
similar to those from the changes in the Amihud’s illiquidity measure.
In addition to the univariate portfolio level analyses, we analyze double-sorted portfolios and per-
form stock level Fama-MacBeth regressions to confirm that the relation between liquidity shocks and
future returns is robust by employing an extensive list of control variables. Liquidity shocks can be cor-
related with several liquidity-related factors that are known to be related to expected returns. Brennan
and Subrahmanyam (1996), Eleswarapu (1997), Brennan, Chordia, and Subrahmanyam (1998), Datar,
Naik, and Radcliffe (1998), Chordia, Roll, and Subrahmanyam (2001), Amihud (2002) and Hasbrouck
(2009) have shown that the stock level illiquidity is an important determinant of expected returns. Chor-
dia, Roll, and Subrahmanyam (2000), Pastor and Stambaugh (2003) and Acharya and Pedersen (2005)
argue that systematic liquidity risk is related to expected stock returns. We control for the level of illiq-
uidity as well as exposures to systematic liquidity risks and find that our results remain intact. Expected
returns can also be affected by the volatility of liquidity if agents care about the risk associated with this
variation or take advantage of time varying liquidity. While Chordia, Subrahmanyam, and Anshuman
(2001) and Pereira and Zhang (2010) find a negative relation between the volatility of liquidity and the
5 The Amihud’s measure of stock level illiquidity has been used by Acharya and Pedersen (2005) and Chordia, Huh, and
Subrahmanyam (2009), among others. This measure is motivated by Kyle’s (1985) notion of liquidity, the response of price to
order flow (Kyle’s lambda). By this definition, a stock is considered to be illiquid if a small trading volume generates a large
price change. Amihud (2002) shows that this measure is positively and strongly related to Kyle’s price impact measure and
the fixed-cost component of the bid-ask spread. Hasbrouck (2009) examines a comprehensive set of daily liquidity measures
and finds that the Amihud’s measure has the highest correlation with the price impact coefficient computed with data on
intraday transactions and quotes.

cross-section of expected returns, Akbas, Armstrong, and Petkova (2010) find a positive relation. Our
results remain significant after controlling for the volatility of liquidity.
We control for other risk factors and stock characteristics that can predict cross-sectional returns:
size and book-to-market (Fama and French (1992, 1993)), price momentum (Jegadeesh and Titman
(1993)), short-term reversal (Jegadeesh (1990)), analysts earnings forecast dispersion (Diether, Malloy,
and Scherbina (2002)), idiosyncratic volatility (Ang, Hodrick, Xing, and Zhang (2006, 2009)) and its
changes, and preference for lottery-like assets (Bali, Cakici, and Whitelaw (2011)). After controlling
for a large set of stock return predictors, the positive relation between liquidity shocks and future returns
remains highly significant.
Furthermore, this economically and statistically significant relation between liquidity shocks and
future returns is robust to microstructure effects and across various subsamples including expansionary
and recessionary periods as well as the five decades in our sample. The results also hold when we use
different portfolio weighting schemes, and when we restrict the sample to NYSE/Amex, NYSE, and
S&P 500 stocks.
Given that liquidity is endogenous, it is possible that the return predictability of liquidity shocks
picks up the market’s underreaction to other news or mechanisms that coincide with liquidity changes.
While a comprehensive exploration of the source of liquidity shocks is beyond the scope of this paper,
we attempt to control for two specific sources that have the potential to affect liquidity.
First, as shown by Beaver (1968), Ball and Brown (1968), and Bernard and Thomas (1989, 1990),
a stock’s earnings announcements can lead to both future return predictability and changes in trading
volume. As changes in volume can be associated with liquidity changes, we control for the information
contained in earnings announcements and find that the return predictability of liquidity shocks is still
statistically and economically significant.
Alternatively, changes in trading volume may be driving the effect of liquidity shocks. As shown
by Gervais, Kaniel, and Mingelgrin (2001), stocks experiencing abnormally high (low) trading volume

over a day or a week also tend to have high (low) abnormal returns in the following month. To ensure
that the effect of liquidity shocks is not driven by unexpected trading volume, we follow Gervais et al.
(2001) and classify stocks into low, normal and high volume portfolios based on volume changes and
define dummy variables based on the portfolio that a stock belongs to. We further construct a contin-
uous volume shock variable in the same fashion as our liquidity shock variable. Our results remain
robust after controlling for both volume change measures, suggesting that the return predictability of
liquidity shocks is distinct from the abnormal volume effect.
Generally speaking, if markets are rational and react to information promptly, value relevant shocks
(information releases and company events) should have been incorporated into prices already and any
of their predictability should have been captured by the predictability of past returns. It is possible that
our results can be explained by investors underreaction to liquidity shocks or some other exogenous
variable that is correlated with liquidity. Nevertheless, our findings remain significant after controlling
for past returns and past earnings surprises, as well as an extensive list of other factors, suggesting that
the return predictability of liquidity shocks is a new finding that can not be explained by mechanisms
proposed in the existing literature.
The paper contributes to the literature on the effect of investor inattention on stock price dynamics
by introducing a new liquidity dimension and by providing evidence that the theory of investor inat-
tention is important in understanding stock market underreactions to liquidity shocks. In addition, the
paper also contributes to the literature on liquidity and stock returns by focusing on the time variation
of liquidity and by providing the first piece of evidence of stock market underreaction to stock level liq-
uidity shocks. The results suggest that liquidity shocks and how the stock market reacts are important
in predicting the cross section of future stock returns.
The remainder of the paper is organized as follows. Section 2 provides the data and variable defi-
nitions. Section 3 examines the cross-sectional predictive relation between liquidity shocks and stock
returns. Section 4 investigates the underlying causes of the asset pricing anomaly. Section 5 provides a

battery of robustness checks for our main findings. Section 6 discusses alternative mechanisms for the
positive relation between liquidity shocks and future returns. Section 7 concludes the paper.
2. Data
Our sample includes all common stocks traded on the NYSE, Amex, and Nasdaq exchanges, covering
the period from July 1963 through December 2010. We eliminate stocks with price per share less
than $5 or more than $1,000. The daily and monthly return and volume data are from CRSP. We adjust
stock returns for delisting in order to avoid survivorship bias (Shumway (1997)).6 Accounting variables
are obtained from the Merged CRSP/Computstat database. Analysts’ earnings forecasts come from
the I/B/E/S dataset and cover the period from 1983 to 2010. Spreads are calculated using Trade and
Quotes (TAQ) data for the period of 1993-2010. The institutional ownership data are from Thompson
13F filings for the period of 1980-2010.
2.1. Measures of liquidity and liquidity shocks
Following Amihud (2002), we measure the illiquidity of stock i in month t, denoted ILLIQ, as the
average daily ratio of the absolute stock return to the dollar trading volume within the month:

|Ri,d |
ILLIQi,t = Avg , (1)
VOLDi,d
6 Specifically, when a stock is delisted, we use the delisting return from CRSP, if available. Otherwise, we assume the
delisting return is -100%, unless the reason for delisting is coded as 500 (reason unavailable), 520 (went to OTC), 551-573,
580 (various reasons), 574 (bankruptcy), or 584 (does not meet exchange financial guidelines). For these observations, we
assume that the delisting return is -30%.

where Ri,d and VOLDi,d are the daily return and dollar trading volume for stock i on day d, respectively.7
A stock is required to have at least 15 daily return observations in month t. The Amihud’s illiquidity
measure is scaled by 106 .
We first use a parsimonious model for liquidity shock (denoted LIQU), defined as the negative
difference between ILLIQ and its past 12-month average:

LIQUi,t = − ILLIQi,t − AV GILLIQi|t−12,t−1 , (2)
where AV GILLIQi|t−12,t−1 is the mean of illiquidity over the past 12 months. Positive (negative) liq-
uidity shocks indicate an increase (decrease) in liquidity relative to its past 12-month average.
We also adopt a parametric methodology to define a conditional measure of liquidity shocks (de-
noted LIQCU). The Amihud’s illiquidity measure of stock i is assumed to follow an ARMA(1,1) pro-
cess:
ILLIQi,t = α0,i + α1,i ILLIQi,t−1 + α2,i εi,t−1 + εi,t , (3)
where εi,t is normally distributed with a time-invariant standard deviation.8 The parameters are esti-
mated via the maximum likelihood method using a 60-month rolling sample that requires a minimum
of 24 observations and is updated on a monthly basis. We define the conditional liquidity shock, de-
noted LIQCU, as the negative difference between the realized ILLIQ of stock i and its conditional mean
estimated from the ARMA(1,1) model in month t, −εi,t in equation (3).9

7 Following Gao and Ritter (2010), we adjust for institutional features of the way that Nasdaq and NYSE/Amex volume
are counted. Specifically, we divide Nasdaq volume by 2.0, 1.8, 1.6, and 1 for the periods prior to February 2001, between
February 2001 and December 2001, between January 2002 and December 2003, and January 2004 and later years, respec-
tively.
8 We used the Akaike Information Criterion (AIC) and Schwarz Bayesian Criterion (SBC) to determine the optimal lag
length for ARMA specification. Since the improvement in terms of AIC and SBC is minimal when we use larger number of
lags, we decided to use the most parsimonious model in equation (3). Moreover, the results from alternative specifications of
the ARMA model are similar to those based on the ARMA(1,1) specification.
9 At an earlier stage of the study, we construct liquidity shocks as standardized shocks, in which liquidity is demeaned and
standardized by its standard deviation. We estimate mean and standard deviation of liquidity using past 12-month liquidity
values. Alternatively, we model liquidity using a ARMA(1,1)-GARCH(1,1) model in which the conditional mean and condi-
tional volatility of liquidity are used to construct standardized liquidity shocks. The results from the two alternative liquidity
shock measures are very similar to those reported in our tables, and are available upon request.

We further adopt an alternative measure of liquidity based on the volume-weighted effective relative
spread (SPRD).10 Spreads are calculated using Trade and Quotes (TAQ) data covering the period of
1993–2010. We obtain National Best Bid and Offer (NBBO) following Hasbrouck’s procedure.11 We
apply several filters to delete invalid trades and quotes. We delete trades: if price is negative or zero or
trading volume is negative or zero; if correction indicator is not 0 (no correction) or 1 (contain corrected
value); if sale condition is not blank, “∗”, “@” or “E”; if first trade of the day; and if price is greater
than 1.5 or less than 0.5 times the lagged price. We delete quotes if quote condition is not 3 (closing),
10 (opening), or 12 (regular); if bid (denoted bid) is less than or equal to zero; if bid is greater than or
equal to offer (denoted ofr); and if o f r − bid > 0.5 × bid. In matching trade and quote files, for data
prior to 1999 we follow the 5-second lag rule proposed by Lee and Ready (1991), and for data in 1999
and later years, we follow Bessembinder and Venkataraman (2010) and do not apply time lag. The
volume-weighted effective relative spread is scaled by 102 .
We construct the stock’s negative spread shock (SPRDU) as:
SPRDUi,t = −(SPRDi,t − AV GSPRDi|t−12,t−1 ), (4)
where AV GSPRDi|t−12,t−1 is the average over the past 12 months. A positive (negative) SPRDU is
associated with decrease (increase) in effective spread relative to its past 12-month average, and hence,
increase (decrease) in liquidity.
2.2. Control variables
We employ a large set of control variables in our tests. Unless otherwise stated, all variables are
measured as of the end of portfolio formation month (i.e., month t) and require a minimum of 15 daily
observations for all variables computed from daily data.12

10 Our findings are robust to alternative spread measures, such as the quoted bid-ask spread and the equal-weighted effective
spread.
11 See http://people.stern.nyu.edu/jhasbrou/.
12 A detailed description of the control variables is provided in the Appendix.

We estimate stock’s market beta following Fama and French (1992), using monthly returns over
the prior 60 months if available (or a minimum of 24 months). The stock’s size (LNME) is computed
as the natural logarithm of the product of the price per share and the number of shares outstanding
(in million dollars). Following Fama and French (1992, 1993, and 2000), the natural logarithm of the
book-to-market equity ratio at the end of June of year t, denoted LNBM, is computed as the book value
of stockholders’ equity, plus deferred taxes and investment tax credit (if available), minus the book
value of preferred stock for the last fiscal year end in t − 1, scaled by the market value of equity at
end of December of t − 1. Depending on availability, the redemption, liquidation, or par value (in that
order) is used to estimate the book value of preferred stock.
Following Jegadeesh and Titman (1993), momentum (MOM) is the cumulative return of a stock
over a period of 11 months ending one month prior to the portfolio formation month. Following Je-
gadeesh (1990), short-term reversal (REV) is defined as the stock return over the prior month. The
stock’s monthly co-skewness (COSKEW) is constructed as in Harvey and Siddique (2000) using the
monthly return observations over the prior 60 months (if at least 24 months are available). The monthly
idiosyncratic volatility of stock i (IVOL) is computed as in Ang, Hodrick, Xing, and Zhang (2006).
The stock’s extreme positive return (MAX) is defined as its maximum daily return in a month fol-
lowing Bali, Cakici, and Whitelaw (2011). Following Diether, Malloy, and Scherbina (2002), analyst
earnings forecast dispersion (DISP) is the standard deviation of annual earnings-per-share forecasts
scaled by the absolute value of the average outstanding forecast.
It is possible that liquidity shocks may coincide with earnings shocks and it is well known that earn-
ings shocks are followed by a post announcement drift. To control for this effect, we follow Ball and
Brown (1968) and Bernard and Thomas (1989, 1990) and construct standardized unexpected earnings
(SUE), defined as changes in earnings from four quarters ago, standardized by its standard deviation
over the past eight quarters (with a minimum of four UE observations available).13
13 Our results are robust to using net assets per share, net book value of equity per share, total liabilities per share, and price
per share as the scaling variables.
10

Since a stock’s liquidity and trading volume are positively related, there is a concern that our liq-
uidity shock variable may be capturing the high volume return premium effect documented by Gervais
et al. (2001). To control for the high volume return premium, we follow Gervais et al. (2001) and clas-
sify stocks into low, normal, and high volume portfolios. If the dollar trading volume on the one-day
formation period is among the highest (lowest) 10% of the daily dollar trading volume over the prior
49 trading days, the stock is classified as a high (low) volume stock, otherwise the stock is classified as
normal volume stock. We then create two dummy variables: the high-volume dummy variable (GKMH )
is 1 if a stock belongs to the high volume group and zero otherwise; the low-volume dummy variable
(GKML ) equal to 1 if a stock resides in the low volume portfolio and zero otherwise. In addition to
the GKM variables, we further control for volume changes by constructing a continuous variable for
abnormal dollar volume (VOLDU) in the same fashion as we define the liquidity shock. That is, we
subtract its past 12-month average from monthly dollar volume.
We also control for a variety of liquidity-based variables. Following Chordia, Subrahmanyam,
and Anshuman (2001), the standard deviation of turnover (SDTURN) is computed as the standard
deviation of monthly turnover (TURN) over the past 12 months. Following Akbas, Armstrong, and
Petkova (2010), the coefficient of variation in the Amihud’s illiquidity (CVILLIQ) is computed as
the standard deviation of the daily Amihud’s illiquidity measure in a month scaled by the monthly
Amihud’s illiquidity measure.
Following Pastor and Stambaugh (2003), we estimate the stock’s liquidity exposure (PS) to inno-
vations in the aggregate liquidity factor.14 To capture covariances of a stock’s own return and liquidity
with the market return and market liquidity, we follow Acharya and Pedersen (2005) and estimate the
four betas. BETA1 is the market beta, BETA2 corresponds to the covariation of a stock’s liquidity with
the market liquidity, BETA3 captures the covariation between a stock’s return and market liquidity, and
BETA4 captures the covariation between a stock’s liquidity and market returns. More specifically, each
month, we classify common stocks listed on NYSE, Amex and Nasdaq into 25 test portfolios sorted on
14 Innovations in aggregate liquidity factor are downloaded from Lubos Pastor’s website.
11

the average daily Amihud’s illiquidity over the previous year using NYSE breakpoints. We then nor-
malize the Amihud’s illiquidity measure as suggested by Acharya and Pedersen (2005) and estimate
the monthly innovations of illiquidity for the market and the test portfolios by extracting the residuals
from an AR(2) model using a 60-month rolling window with at least 24 monthly observations. Using
these illiquidity innovations and returns, we estimate the liquidity betas for testing portfolios and assign
the betas of the illiquidity portfolio to stocks that comprise it.
We further control for a stock’s exposure to the fixed and variable components of Sadka’s (2006)
liquidity factor.15 For each month, a stock’s illiquidity risk loadings on the fixed and the variable
components (denoted SADKAF and SADKAV, respectively) are estimated using monthly return data
over the prior 60 months with a minimum of 24 monthly observations available after controlling for the
monthly market, size and book-to-market factors.
Finally, in Section 4, we investigate the pricing effect associated with liquidity shocks in conjunc-
tion with alternative measures of investor attention. We use several measures to capture the degree
of investor attention: (i) stock size (LNME); (ii) analyst coverage (CVRG), computed as the natural
logarithm of the number of analysts covering the stock in the portfolio formation month; and (iii) in-
stitutional holdings (INST), defined as quarterly fractional institutional ownership as of the portfolio
formation month.16
2.3. Summary statistics
We first examine the time series properties of stock level illiquidity measures and find that the ILLIQ
and SPRD variables are highly auto-correlated with an average AR(1) coefficient of 0.69 and 0.74
across all stocks over the full sample period. The autocorrelation coefficients are consistent with evi-
dence established in the previous literature that shocks to liquidity have persistent effects: a negative
liquidity shock leads to lower levels of future liquidity, and vice versa.
15 We download the time series of the monthly fixed and variable components of the illiquidity factor covering the period
of April 1984 to December 2010 from Ronnie Sadka’s webpage.

16 Following Cremers and Nair (2005), INST is set to zero if missing in the database.
12

Panel A of Table 1 provides the time-series averages of the cross-sectional descriptive statistics
for the aforementioned variables. Consistent with improved stock liquidity over time, the mean and
median of the alternative measures of liquidity shocks are positive over our sample period. Liquidity
shocks also show substantial cross-sectional variation with an average standard deviation in the range
of four (when liquidity shock is measured by SPRDU), eight (when measured by LIQU) and to twelve
(when measured by LIQCU) times the corresponding mean.
Panel B of Table 1 reports the time-series averages of the cross-sectional correlation coefficients for
the variables. Panel B reveals that the alternative measures of liquidity shocks are highly correlated with
an average correlation coefficient ranging from 21% (between SPRDU and LIQCU), 43% (between
LIQU and SPRDU) to 53% (between LIQU and LIQCU). The average correlation coefficients between
the contemporaneous stock return (REV) and LIQU, SPRDU and LIQCU are, respectively, 13%, 12%
and 11%, and highly significant. This is consistent with liquidity is priced, that a positive and persistent
liquidity shock reduces future liquidity risk premium and increases the contemporaneous stock price.
However, there is preliminary evidence that the market continues to react to liquidity shocks in the
future months: the average correlation coefficient between liquidity shocks, proxied by LIQU, SPRDU
and LIQCU, and one-month ahead stock returns (RET) are, respectively, 2.4%, 2.0% and 1.7%, all
positive and significant at the 1% level. The liquidity shock variables are also highly correlated with
many known return predictors such as illiquidity level (ILLIQ), size (LNME), momentum (MOM), and
return volatility (IVOL). LIQU is positively related to VOLDU, but negatively correlated with GKMH ,
suggesting that our liquidity shock variable is distinct from the volume change variable analyzed in
Gervais et al. (2001). These variables serve as our controls in the following analysis.
3. Cross-sectional Relation between Liquidity Shocks and Stock Returns
The significantly positive correlation between liquidity shocks and one-month ahead stock returns sug-
gests that negative liquidity shocks (reductions in liquidity) are related to lower future stock returns, and
13

vice versa. In this section, we perform formal analysis, and show that the pricing effect documented in
this paper cannot be explained by other risk factors and stock characteristics that are known to predict
future stock returns in the cross-section.
3.1. Univariate portfolio-level analysis
We begin our empirical analysis with univariate portfolio sorts. For each month, we sort common
stocks trading on NYSE/Amex/Nasdaq into decile portfolios based on one of the three proxies for
liquidity shocks – LIQU, SPRDU and LIQCU, and compare the performance of high liquidity-shock
portfolio to low liquidity-shock portfolio in the contemporaneous and the following months. The NYSE
breakpoints are used to alleviate the concern that the CRSP decile breakpoints are distorted by the large
number of small Nasdaq and Amex stocks.17
We first examine the effect of liquidity shocks on same-month returns. Table 2 reports the averages
of returns, three-factor Fama and French (1993) alphas of each of these LIQU-sorted deciles, as well as
portfolio characteristics: liquidity shock (LIQU), monthly illiquidity level (ILLIQ), and market share.
The t-statistics are calculated using Newey-West (1987) standard errors and are reported in parentheses.
The average liquidity shock (LIQU) increases from -0.90 in Decile 1 to 1.31 in Decile 10, which implies
that stocks in the lowest LIQU decile (Decile 1) have negative liquidity shocks (i.e., decrease in the level
of liquidity), whereas stocks in the highest LIQU decile (Decile 10) have positive liquidity shocks (i.e.,
increase in the level of liquidity).
Table 2 shows a positive relation between LIQU and the same-month returns: the average return for
stocks in the highest liquidity shock decile is 4.51% for the equal-weighted returns and 5.27% for the
value-weighted returns. Those in the lowest liquidity shock decile post an equal-weighted average re-
turn of -0.39% and a value-weighted average return of 0.04%. The equal-weighted and value-weighted
return differences between the highest and lowest LIQU decile portfolios are, respectively, 4.90% and
17 At an earlier stage of the study, we also used the CRSP breakpoints with equal number of stocks in decile portfolios. The
results from univariate and bivariate portfolio sorts based on the CRSP breakpoints are similar to those reported in our tables,
and they are available upon request.
14

5.23% that are highly significant and cannot be explained by the Fama-French factors.18 These results
indicate that the initial reaction to liquidity shocks is consistent with the findings of positive illiquidity
risk premium in the prior literature: a negative and persistent liquidity shock increases future expected
illiquidity and therefore leads to an immediate decrease in the stock price due to a higher liquidity
premium.
Table 2 also reports some characteristics of the portfolios sorted by liquidity shocks. As shown in
the last two columns, stocks in the extreme deciles (Decile 1 and 10) are relatively smaller and more
illiquid compared to stocks in Deciles 2 to 9. More specifically, stocks in Decile 1 (with the lowest
liquidity shocks) have an average market share of 4.73% and average illiquidity of 2.65, whereas stocks
in Decile 10 (with the highest liquidity shocks) have an average market share of 2.84% and average
illiquidity of 0.99. Note that liquidity shocks do not seem to have a monotonic relation with stock size
or the level of illiquidity.
Table 3 presents the average one-month ahead returns on portfolios sorted by liquidity shocks. The
first four columns present results with LIQU, based on the changes in the Amihud’s illiquidity measure,
as the measure of a liquidity shock. The equal-weighted (value-weighted) portfolio raw returns increase
almost monotonically with liquidity shocks: from 0.51% (0.43%) per month for the lowest LIQU decile
to 1.69% (1.60%) per month for the highest LIQU decile. The return differential between Decile 10
and Decile 1 is 1.18% for the equally weighted portfolio and 1.17% for the value-weighted portfolio.
The corresponding Fama-French three-factor adjusted returns are 1.23% and 1.17%, respectively. All
the return differentials are statistically significant at the 1% level.
Columns 5-8 present results with liquidity shocks measured as shocks in the bid-ask spreads
(SPRDU).19 The equal-weighted (value-weighted) raw return on the SPRDU portfolios increases with
18 In the online appendix, Panels A and B of Table A1 summarize the contemporaneous relation between liquidity shocks
and stock returns revealed by univariate portfolio sorts on the two other liquidity shock measures: SPRDU and LIQCU.
The results are qualitatively similar to those based on LIQU. The average contemporaneous return differences between the
highest and the lowest liquidity shock portfolios are in the range of 4.42% to 5.26% varying with the liquidity shock proxy
and weighting scheme used in the analysis.
19 We should note that SPRDU are calculated based on TAQ data for the period of 1993-2010, while LIQU and LIQCU are
calculated from CRSP data from 1963-2010.
15

SPRDU as well: from 0.50% (0.56%) per month for the lowest SPRDU decile portfolio to 1.42%
(1.23%) per month for the highest SPRDU decile portfolio. The equal-weighted (value-weighted) raw
return differences and the corresponding alphas are, respectively, 0.92% and 0.98% (0.67% and 0.79%)
per month between the High- and Low-SPRDU portfolios. These return differentials are strongly sta-
tistically significant as well.
Columns 9-12 report results when liquidity measure is based on LIQCU, residuals from the ARMA(1,1)
regression with the Amihud’s illiquidity measure. The equal-weighted (value-weighted) raw return on
the LIQCU portfolios increases monotonically: from 0.77% (0.60%) per month for Decile 1 to 1.52%
(1.40%) per month for Decile 10. The equal-weighted (value-weighted) raw return differences and the
corresponding alphas are, respectively, 0.75% and 0.76% (0.80% and 0.78%) per month between the
High- and Low-LIQCU portfolios and they are highly significant.
Overall, these results indicate that, regardless of the liquidity shock proxies or the portfolio weight-
ing scheme that we use, a portfolio that buys stocks in the highest liquidity shock decile and shorts
stocks in the lowest liquidity shock decile yields both economically and statistically significant returns
ranging between 0.67% to 1.23% in the next month. Combined with the previous result that liquidity
shocks are also positively associated with contemporaneous month stock returns, our findings suggest
that the stock market under-reacts to liquidity shocks and the reaction continues in the following month.
3.2. Bivariate portfolio-level analysis
As discussed earlier, liquidity shocks are correlated with many well-known characteristics that forecast
cross-sectional stock returns, such as level of illiquidity, past return characteristics (reversal, momen-
tum), co-skewness, idiosyncratic volatility, analyst disagreement, and demand for lottery-like stocks.
As such, there is some concern that our liquidity shock proxies may capture effects other than liquidity
shocks. We control for these other factors with bivariate sorts in this subsection and Fama-MacBeth
regressions in Section 3.4.
16

We perform bivariate sorts on LIQU in combination with market beta (BETA), size (LNME), book-
to-market ratio (LNBM), momentum (MOM), short-term reversal (REV), co-skewness (COSKEW), id-
iosyncratic volatility (IVOL), extreme positive daily return (MAX), analyst dispersion (DISP), earnings
shocks (SUE), a variety of liquidity-based variables including Amihud’s illiquidity measure (ILLIQ),
coefficient of variation in Amihud’s illiquidity (CVILLIQ), standard deviation of turnover (SDTURN),
liquidity exposure (PS) of Pastor and Stambaugh (2003), liquidity exposures (BETA1 to BETA4) of
Acharya and Pedersen (2005), and exposures to the fixed and variable components of Sadka’s liquidity
factor (SADKAF and SADKAV), and two variables for abnormal dollar trading volume (GKM and
VOLDU).20
Table 4 reports the results of conditional bivariate sorts.21 Stocks are first sorted into quintile
portfolios based on one of the aforementioned control variables except GKM, for which stocks are first
sorted into high, medium and low groups following Gervais et al. (2001), and then into LIQU quintiles
within each control variable quintile. We report the returns of the LIQU portfolios, averaged across
the control groups to produce quintile portfolios with dispersion in LIQU but with similar levels of the
control variable. The predictive power of LIQU remains intact in bivariate portfolios. The average raw
return differences, ranging from 0.75% to 1.35% per month, are all significant at the 1% level based
on the Newey-West t-statistics. The corresponding alphas are also significantly positive, ranging from
0.85% to 1.36% per month.
Table A2 in the online appendix reports the full return matrix for the double sorted portfolios.
The return difference and the alpha between the High- and Low-LIQU portfolios for each control
quintile are all positive and highly significant. In particular, Panel U of Table A2 shows that the return
differential for High- and Low-LIQU portfolio remains positive and significant at 0.71% per month
even for the lowest abnormal volume groups defined as in Gervais et al. (2001), suggesting that the
predictive power of liquidity shocks is not due to the high volume return premium effect. Overall,
20 Due to space constraints, we report the results of bivariate sorts based on the two alternative liquidity shock measures,
SPRDU and LIQCU in the online appendix, Table A3. It shows that the effect of liquidity shocks on predicting one-month
ahead returns remains robust after controlling for each of these other factors.
21 Our findings remain intact when independent bivariate sorts are used. The results are available upon request.
17

the double-sorted portfolio results confirm that these aforementioned control variables alone fail to
subsume the return predictive power of the liquidity shock variables.
3.3. Controlling for volume and volatility shocks
Two of our liquidity shock variables (LIQU and LIQCU) depend on the Amihud’s illiquidity measure
that can be viewed as volatility over volume. Hence, the predictive power of liquidity shocks may
potentially be driven by shocks to volume and/or volatility. We investigate this issue based on the
conditional bivariate sorts on liquidity shocks after controlling for volume and volatility shocks.
We start our analysis by forming 5×5 bivariate portfolios of liquidity shocks (LIQU) and unex-
pected shocks to volume (VOLDU). Stocks are first sorted into quintile portfolios based on VOLDU,
and then into LIQU quintiles within each VOLDU quintile. Panel A of Table 5 reports average re-
turns on 5×5 VOLDU & LIQU portfolios. In the lowest VOLDU quintile portfolio, average returns on
LIQU portfolios increase from 0.45% to 1.27% per month, with an average return difference of 0.82%
(t-statistic = 8.10) between Low and High LIQU portfolios. The corresponding alpha is 0.93% per
month with a t-statistic of 9.72. Similarly, in the highest VOLDU quintile portfolio, average returns on
LIQU portfolios increase monotonically from 0.97% to 1.99% per month, with an average return differ-
ence of 1.02% (t-statistic = 5.64) between Low and High LIQU portfolios. The corresponding alpha is
also positive, 0.87% per month, and highly significant. A notable point in Panel A of Table 5 is that in
almost all VOLDU quintiles, average returns on LIQU quintile portfolios increase monotonically as we
move from the lowest to highest LIQU quintile. The last column in Panel A of Table 5 presents returns
averaged across the VOLDU quintiles to produce quintile portfolios with dispersion in LIQU but with
similar levels of VOLDU. It shows that when moving from the lowest to highest LIQU quintile, the
monthly return averaged across the VOLDU quintiles increases from 0.62% to 1.67%, with an average
return difference of 1.05% (t-statistic = 7.94). The corresponding alpha has a similar magnitude and
highly significant as well. These results provide evidence that after controlling for unexpected shocks
to volume, the predictive power of liquidity shocks remains intact in bivariate portfolios. In the next
18

subsection, we will show that liquidity shocks predict future returns after controlling for VOLDU and
all other control variables in Fama-MacBeth regressions.
Since our main findings survive volume controls, one remaining issue is whether investors are just
underreacting to volatility shocks. Previous studies have documented a volatility feedback effect, that
an increase in volatility requires a higher rate of return from the asset, which leads to a fall in the as-
set price in the contemporaneous period (see, e.g., French et al., 1987; and Campbell and Hentschel,
1992). While the contemporaneous relation is well known, the predictive relation between volatility
shocks and future returns at individual stock level is not.22 It is possible that stock market underreacts
to volatility shocks, thus volatility shocks are accompanied by lower returns both in the contempo-
raneous period and in the future.23 To properly control for volatility shocks, we form 5×5 bivariate
portfolios of liquidity shocks (LIQU) and unexpected shocks to idiosyncratic volatility (IVOLU). Sim-
ilar to our liquidity shock variables defined in equations (2) and (4), we measure unexpected shocks to
idiosyncratic volatility (IVOLU) as:

IVOLUi,t = IVOLi,t − AV GIVOLi|t−12,t−1 , (5)
where AV GIVOLi|t−12,t−1 is the mean of idiosyncratic volatility over the past 12 months.
Once we generate volatility shocks (IVOLU), stocks are first sorted into quintile portfolios based on
IVOLU, and then into LIQU quintiles within each IVOLU quintile. Panel B of Table 5 reports average
returns on 5×5 IVOLU & LIQU portfolios. In the lowest IVOLU quintile portfolio, average returns
on LIQU portfolios increase monotonically from 0.65% to 1.96% per month, with an average return
difference of 1.31% (t-statistic = 7.46) between Low and High LIQU portfolios. The corresponding
alpha is 1.33% per month with a t-statistic of 7.52. Similarly, in the highest IVOLU quintile portfolio,
22 The negative relation between volatility shocks and contemporaneous returns can also be driven by the leverage effect
proposed by Black (1976) and Christie (1982), that is, as asset prices decline, companies’ leverage increases and they become
riskier, hence volatility also increases (see, e.g., Nelson, 1991; Engle and Ng, 1993, Bekaert and Wu, 2000, Bollerslev,
Litvinova, and Tauchen, 2006 and An, Ang, Bali, and Cakici, 2013). We control for past returns throughout the analysis to
account for this effect.
23 Bali, Scherbina, and Tang (2009) show that stocks that experience a sudden increase in idiosyncratic volatility earn
abnormally high contemporaneous returns but significantly underperform otherwise similar stocks in the future.
19

average returns on LIQU portfolios also increase monotonically from -0.02% to 1.43% per month, with
an average return difference of 1.45% (t-statistic = 6.24). The corresponding alpha is 1.49% per month
with a t-statistic of 6.97. A notable point in Panel B is that in all IVOLU quintiles, average returns on
LIQU quintile portfolios increase monotonically as we move from the lowest to highest LIQU quintile.
The last column in Panel B of Table 5 presents returns averaged across the IVOLU quintiles to produce
quintile portfolios with dispersion in LIQU but with similar levels of IVOLU. As shown in the last
column, when moving from the lowest to highest LIQU quintile, the monthly return averaged across
the VOLDU quintiles increases from 0.57% to 1.78%, with an average return difference of 1.21%
(t-statistic = 7.91) between Low and High LIQU portfolios. The corresponding alpha has a similar
magnitude and highly significant as well. These results indicate that after controlling for volatility
shocks, the predictive power of liquidity shocks remains intact.24
Another potential concern might be the correlation between spread and volatility that may translate
into a correlation between shocks to spread and shocks to volatility. Panel B of Table 1 shows that
the average cross-sectional correlation between SPRD and IVOL is about 40%. Since the spread is
correlated with volatility, it is useful to disentangle the portion of the spread shocks (SPRDU) driven
by volatility (or volatility shocks), and examine the orthogonal component of SPRDU for predicting
future stock returns. To investigate this issue, we first run firm-level contemporaneous cross-sectional
regressions of SPRDU on IVOL, and then use the residuals of these monthly cross-sectional regressions
(that are orthogonal to idiosyncratic volatility) to form a univariate long-short equity portfolio. The
first column in Table A5, Panel A of the online appendix shows that moving from Decile 1 to 10, the
average return on SPRDU portfolios increases from 0.44% to 1.46% per month, with an average return
difference of 1.02% per month with a t-statistic of 5.91 between Low and High SPRDU portfolios.
The corresponding alpha is 0.94% per month with a t-statistic of 5.17. Alternatively, we generate the
24 To test whether these findings are sensitive to alternative measures of liquidity shocks, we replicated our analysis in Table
5 using the shock to spread (SPRDU) and the conditional measure of liquidity shock (LIQCU). Specifically, we form 5×5
bivariate portfolios of VOLDU & SPRDU as well as IVOLU & SPRDU. We also form 5×5 bivariate portfolios of VOLDU &
LIQCU as well as IVOLU & LIQCU. As presented in Table A4 of the online appendix, within VOLDU and IVOLU quintiles,
average returns on SPRDU and LIQCU portfolios increase monotonically as we move from the lowest to highest liquidity
shock quintile. The average return and alpha differences between Low and High liquidity shock portfolios are all positive and
highly significant after controlling for VOLDU and IVOLU.
20

orthogonal component of SPRDU with respect to volatility shocks (instead of volatility levels). We
first run contemporaneous cross-sectional regressions of SPRDU on IVOLU, and then use the residuals
that are orthogonal to volatility shocks to form a univariate portfolio. The last two columns of Table A5
show that moving from Decile 1 to 10, the average return on SPRDU portfolios increases from 0.61% to
1.37% per month, with an average return difference of 0.76% per month with a t-statistic of 4.51. The
corresponding alpha is also positive, 0.77% per month, and highly significant with a t-statistic of 4.57.
Panel B of Table A5 presents multivariate Fama-MacBeth regressions with the orthogonal components
of SPRDU. The average slopes on SPRDU (orthogonal to IVOL and IVOLU) remain positive and
highly significant after controlling for all other return predictors.
In sum, our liquidity shock measures continue to predict future returns after controlling for volatility
and volume shocks, suggesting that the return predictability is consistent with stock market underre-
action to liquidity shocks, rather than underreaction to volume or volatility shocks. In the following
subsection, we perform multivariate Fama-MacBeth regressions of liquidity shocks on future returns
while simultaneously controlling for an extensive list of variables.
3.4. Stock level cross-sectional regressions
While portfolio-level analysis has an advantage of being nonparametric, it does not allow us to account
for all the control variables jointly. To check whether the predictive power of liquidity shocks remains
strong after simultaneously controlling for the competing predictors of stock returns, we run monthly
cross-sectional predictive regressions of the form:
Ri,t+1 = αt+1 + γt+1 LIQshock

i,t + ϕt+1 Xi,t + εi,t+1 , (6)
where Ri,t+1 is the realized excess return on stock i in month t + 1, LIQshock

i,t represents one of the three
alternative measures of liquidity shock of stock i in month t: LIQU, SPRDU, and LIQCU. Xi,t is a
vector of control variables for stock i in month t.
21

We start with the baseline model, where the control variables are the market beta (BETA), log mar-
ket capitalization (LNME), and log book-to-market ratio (LNBM). We then add the other usual suspects
including the momentum (MOM), short-term reversal (REV), co-skewness (COSKEW), idiosyncratic
volatility (IVOL), maximum daily return in the previous month (MAX), analyst dispersion (DISP), and
the Amihud’s illiquidity measure (ILLIQ). Next, we add a variety of liquidity-based variables includ-
ing the coefficient of variance in the Amihud’s illiquidity (CVILLIQ), standard deviation of turnover
(SDTURN), Pastor and Stambaugh (2003) liquidity beta (PS), Acharya and Pedersen (2005) liquidity
betas (BETA1 to BETA4), exposures to the fixed and the variable components of Sadka’s liquidity fac-
tor (SADKAF and SADKAS), unexpected earnings (SUE), and two alternative measures of abnormal
dollar trading volume: the dummy variables for abnormal trading volume variable constructed follow-
ing Gervais et al. (2001) – GKMH for a stock with abnormally high dollar trading volume, GKML for
a stock with abnormally low dollar volume; and abnormal dollar trading volume for a stock in month t
relative to its prior 12-month average (VOLDU).25
Table 6 presents the time-series averages of the slope coefficients from the stock level Fama and
MacBeth (1973) cross-sectional regressions of one-month ahead stock returns on liquidity shocks with
all cross-sectional predictors controlled for simultaneously, where abnormal trading volume in previous
month is measured by either the dummy variables (GKMH and GKML ) or the continuous VOLDU
variable. The t-statistics computed with Newey-West standard errors are shown in parentheses.26
Table 6 shows that, depending on the two alternative abnormal trading volume proxies used, the
average slope coefficients of LIQU are 0.18 and 0.20 and highly significant. The economic significance
of the average slope coefficients of LIQU can be interpreted based on the long-short equity portfolios.
As reported in Table 2, the difference in LIQU values between average stocks in the high and low LIQU
deciles is 2.22. Hence, the average slopes of 0.20 and 0.18 imply that a portfolio short-selling stocks
25 In some specifications we also controlled for shocks to idiosyncratic volatility and find this variable to be insignificant.
To streamline the presentation, we defer those specifications in Table A6 of the online appendix.
26 Table A7 in the online appendix reports the time-series averages of the slope coefficients from the stock level Fama and
MacBeth (1973) cross-sectional regressions of one-month ahead stock returns on liquidity shocks and various combinations
of the control variables. The average slope coefficients of the liquidity shock proxies remain positive and significant at the
1% level based on the Newey-West t-statistics.
22

with the largest decrease in liquidity (stocks in Decile 1) and buying stocks with the largest increase
in liquidity (stocks in Decile 10) will generate a return in the following month by between 0.44% and
0.40%, controlling for everything else.27
Similarly, the average slope coefficients of SPRDU are 0.554 and 0.632, respectively, and highly
significant, implying that a portfolio short-selling stocks with the largest increase in spread (stocks in
Decile 1) and buying stocks with the largest decrease in spread (stocks in Decile 10) will yield a return
in the following month by between 1.04% and 0.90%, controlling for everything else.28 Finally, the
average slope coefficients of LIQCU are 0.18 and 0.15, respectively, and highly significant, implying
that a portfolio short-selling stocks with the largest decrease in liquidity (stocks in Decile 1) and buying
stocks with largest increase in liquidity (stocks in Decile 10) will generate a return in the following
month by between 0.42% and 0.35%, controlling for everything else.29
The average slope coefficients on the control variables are in line with the earlier studies. Specif-
ically, the negative coefficient on stock size is consistent with Fama and French (1992, 1993). MOM
is positive, while REV is negative, consistent with price momentum (Jegadeesh and Titman (1993))
and short-term reversal (Jegadeesh (1990)). Idiosyncratic volatility is negative and significant as in
Ang, Hodrick, Xing, and Zhang (2006). Analysts earnings forecast dispersion is negative and signif-
icant as in Diether, Malloy, and Scherbina (2002). The level of Amihud’s illiquidity is positive and
significant, consistent with illiquidity risk premium shown in Amihud and Mendelson (1986) and sub-
sequent studies. While the variation in illiquidity is positive but insignificant, standard deviation in
turnover is negative and significant as in Chordia, Subrahmanyam, and Anshuman (2001) and Pereira
and Zhang (2010). The exposure to systematic liquidity risk as proposed by Pastor and Stambaugh
27 Note that Table 6 does not include SPRD as a control variable when liquidity shocks are measured as LIQU or LIQCU,
as employing SPRD greatly reduces the length of the sample. For robustness check, We include SPRD as a control variable
for these two liquidity shock measures and find the results to be similar. The results are shown in Panels A and C of Table
A7.
28 At an earlier stage of the study, we construct liquidity shock based on equal-weighted quoted spread (QSPRD), calculated
as the negative QSPRD, demeaned using the past 12-month QSPRD as the mean. The results are qualitatively similar to those
based on volume-weighted relative effective spread, and are summarized in Table A8 of the online appendix.
29 As reported in the online appendix, Panels A and B of Table A1 show that the differences in SPRDU and LIQCU values
between average stocks in High and Low liquidity shock deciles are 1.64 and 2.36, respectively.
23

(2003) is positive, albeit insignificant. The exposure to the four Acharya and Pedersen (2005) betas
are largely insignificant, with the exception of BETA3 when liquidity shocks are measured as SPRDU.
Similarly, the Sadka (2006) fixed and variable liquidity betas are insignificant. Earnings surprises are
positive and highly significant, consistent with earnings momentum as documented by Bernard and
Thomas (1989) and subsequent papers. The high volume dummy variable, GKMH , and abnormal trad-
ing volume variable, VOLDU, are both positive and significant, consistent with the high volume return
premium proposed by Gervais et al. (2001).
Overall, the Fama-MacBeth regression results confirm that, even after jointly controlling for a large
set of variables, our liquidity shock variables have economically and statistically significant predictive
power for future stock returns. Furthermore, although liquidity shocks may appear to be related to
changes in trading volume, the effect of liquidity shocks on future returns remain robust after control-
ling for the Gervais et al. (2001) high volume return premium effect.
4. Investigating the Underlying Mechanism of Underreaction
Our finding of the positive link between stock level liquidity shocks and future stock returns is incon-
sistent with the setting in which public information is incorporated into prices immediately. In such
setttings, given that liquidity shocks have persistent effects and that the level of illiquidity has found to
be positively priced, negative liquidity shocks should lead to a higher risk premium and thus an instan-
taneous price decrease (lower contemporaneous return) and higher future returns. The opposite should
also be true for positive liquidity shocks.
As described earlier, Table 2 shows a positive contemporaneous relation between liquidity shocks
and stock returns. This initial reaction of liquidity shocks is consistent with the argument put forth in the
prior literature: a negative liquidity shock should lead to an immediate decrease in the stock price due
to a higher liquidity risk premium and vice versa. However, Tables 3–6 show that the market reaction is
incomplete in the contemperaneous month and future stock returns continue to drift positively with the
24

past liquidity shocks. Our evidence thus suggests that the market underreacts to the liquidity shocks.
The full effect of liquidity shocks is reflected in prices only gradually over time, resulting in return
continuations in the following months.
To gain insight on the horizon of the underreaction, we examine the effect of liquidity shocks
on future returns over various holding periods. We form long-short equity portfolios based on past
liquidity shocks and investigate the performance of high vs. low liquidity shock (LIQU) portfolios over
months t + 1 to t + 12. Figure 1 depicts the monthly return differences between the highest LIQU and
lowest LIQU deciles for 1 to 12 months after portfolio formation. The dashed lines indicate the 95%
confidence bands, calculated based on the Newey and West (1987) standard errors. The figure shows
that the return differentials between the highest LIQU and lowest LIQU deciles continue to be positive
for up to 7 months after the shock. This evidence suggests that there exists considerable underreaction
to stock level liquidity shocks and the underreaction can last for a substantial amount of time. The
horizon of underreaction documented here is consistent with the pattern established by other empirical
papers. Bernard and Thomas (1989) find that underreaction to earnings announcements can last for
up to a quarter, until the next earnings announcement. Hong, Lim, and Stein (2000) find that slow
information diffusion can lead to stock market underreaction, which results in return predictability for
10 months or longer (especially for stocks with low analyst coverage). Hirshleifer, Lim, and Teoh
(2009) show that the underreaction to earnings news surrounded by other information events can be
significant in the 60-day cumulative returns after the announcement.
We explore two possible causes of stock market underreaction to liquidity shocks: limited investor
attention and illiquidity. One mechanism proposed in the literature to explain underreaction to infor-
mation is investor attention. Kahneman’s (1973) theory of attention argues that attention is a scarce
cognitive resource. Subsequently, a large body of psychological research shows that there is a limit to
the central cognitive-processing capacity of the human brain.30 The implication of attention theory in
financial markets is that limited availability of time and cognitive resources imposes constraints on how
30 See Pashler and Johnston (1998) for a review of these studies.
25

fast investors can process information. Theoretical models have shown that limited investor attention
can lead to securities market underreaction to information and thus slow price adjustments (Hirshleifer
and Teoh, 2003, Peng, 2005, Peng and Xiong, 2006, and Hirshleifer, Lim, and Teoh, 2011). These
predictions have been confirmed by recent empirical findings that securities prices underreact to value
relevant public information due to limited investor attention.31
Compared to the types of information studied in the aforementioned literature (earnings news,
demographic information, new products, returns of related stocks, etc.), liquidity shocks are not well-
defined, less tangible, and their pricing implications are harder to interpret by average investors. As a
result, investors are more likely to ignore this “news”. In this case, when stock level liquidity decreases,
the effect of increased risk premium and lower stock prices is not fully incorporated by the stock
market immediately, and the negative price impact spills over to future months. The attention-based
underreaction hypothesis further predicts that the return predictability of liquidity shocks should be
stronger for stocks which investors pay less attention to.
Illiquidity may also result in delays in price adjustments: if information is revealed through trading,
then for illiquid stocks that are harder to trade, information is revealed more slowly. This mechanism
makes sense especially for private information. The only way for these types of information to be
incorporated into prices is through trading, and the informed investors trade less aggressively when liq-
uidity is low or when transaction costs are high. The mechanism is less obvious for public information
such as publicly observable changes in liquidity (especially given that our liquidity shocks are simple
to compute). In a market in which participants such as market makers and traders immediately react to
public information, prices can be updated without trading. However, if market participants are hetero-
geneous in processing information, together with limits to arbitrage, illiquidity may still lead to slow
price adjustment following public information arrival. Hence, it is plausible that illiquidity can hamper
price discovery, which leads to slow price adjustment following liquidity shocks. The illiquidity-based
31 See,
for example, Huberman and Regev (2001), Hirshleifer, Hou, Teoh, and Zhang (2004), Hou and Moskowitz (2005),
Hong, Torous, and Valkanov (2007), DellaVigna and Pollet (2007, 2009), Cohen and Frazzini (2008), Hirshleifer, Lim, and
Teoh (2009), and Hirshleifer, Hsu, and Li (2012).
26

underreaction hypothesis predicts that the positive return predictability of liquidity shocks should be
stronger for less liquid stocks.
To empirically test the attention-based underreaction hypothesis, we form subsamples that vary
by the degree of investor attention and compare the relation between liquidity shocks and subsequent
returns in these subsamples.
Following Hirshleifer and Teoh (2003), Peng (2005), and Hirshleifer, Hsu, and Li (2012), we adopt
stock size and analyst coverage as proxies for investor attention. Smaller stocks and stocks with lower
analyst coverage receive less attention from investors. As a result, we expect these stocks to exhibit
more delayed reaction to information contained in liquidity shocks, and thus liquidity shocks can gener-
ate greater return predictability. Small stocks and stocks with lower analyst coverage have slower infor-
mation diffusions, which is also consistent with evidence found in price momentum effect (Hong, Lim,
and Stein (2000)), stock return lead-lags (Brennan, Jegadeesh, and Swaminathan (1993); Hong, Torous,
and Valkanov (2007); Hou (2007); Cohen and Frazzini (2008)), post earnings announcement drifts
(Chambers and Penman, 1984; Bernard and Thomas, 1989), and the accrual anomaly (Mashruwala,
Rajgopal, and Shevlin (2006)). In addition, since institutional investors are more likely to pay more
attention to individual stocks than retail investors due to their expertise and economies of scale in gath-
ering information, stocks with more institutional ownership tend to receive more investor attention.
Thus, we use institutional ownership as our third attention proxy, with the caveat that institutional
ownership may also capture the relaxation of short sale constraints. The attention-based underreaction
mechanism predicts that there should be a stronger positive relation between liquidity shocks and future
returns for small stocks, and stocks with low analyst coverage and low institutional ownerships.
To test this prediction, we first sort stocks into quintile portfolios based on an attention proxy, and
then within each proxy quintile, stock are sorted into liquidity shock quintile portfolios. We follow the
prior literature (for example, Hong et al. 2000) and use the NYSE breakpoints. Table 7 presents 5 × 5
bivariate portfolio returns and return differentials, with Newey-West t-statistics reported in parentheses.
27

Panels A-C use stock size, analyst coverage, and institutional ownership as alternative proxies for
investor attention.
Panel A shows that a portfolio that is long in stocks with positive liquidity shocks (increase in
liquidity) and short in stocks with negative liquidity shocks (decreases in liquidity) leads to a monthly
return of 145 basis points for stocks in the smallest size quintile and a return of only 43 basis points
for stocks in the largest size quintile, the difference is 102 basis points per month, and statistically
significant. Results are similar with the risk-adjusted returns; the Fama-French three-factor alpha on
the long-short portfolio based on LIQU is 1.50% per month in the smallest size quintile, whereas the
corresponding alpha is only 0.52% per month in the biggest size quintile, the difference is a significant
98 basis points per month.
Panels B and C show similar results. The return differential for the long-short portfolio based on
LIQU is high for the quintile with the lowest analyst coverage and institutional ownership, 128 and
147 basis points per month, respectively, and low for the quintile with the highest analyst coverage
and institutional ownership, 49 and 71 basis points per month. The difference of long-short portfolio
return differential across analyst coverage and institutional ownership quintile is highly significant for
both the raw returns and for the abnormal returns. It is also worth noting that, Kaniel, Ozoguz and
Starks (2012) find that the high volume return premium effect originally documented by Gervais et al.
(2001) is actually increasing in analyst coverage, contrary to our finding that the return predictability
of liquidity shocks is decreasing in analyst coverage. This contrast further suggests that the two effects
are distinct.
Overall, these results support the attention-based underreaction hypothesis that, market’s underre-
action to liquidity shocks is stronger and more significant for stocks that receive less investor attention:
small, less-covered stocks, and stocks minimally held by institutional investors.
To test whether illiquidity-driven slow price adjustment can also contribute to market’s underre-
action to liquidity shocks, we analyze how the degree of underreaction is related to the level of the
28

stock’s illiquidity. We first sort stocks into quintiles every month based on the Amihud’s illiquidity
measure (ILLIQ), and then within each ILLIQ quintile, stocks are sorted into quintiles on liquidity
shocks (LIQU). Panel D of Table 7 reports the average returns for each of the 5 × 5 portfolios of ILLIQ
and LIQU, the return difference (High−Low) between the highest and the lowest LIQU quintiles within
each ILLIQ quintile, and the three-factor alpha. The return differences and three-factor alphas remain
significantly positive across all ILLIQ quintiles. Moving from the lowest to the highest ILLIQ quintile,
the return difference between Quintile 5 and Quintile 1 LIQU portfolios increases from 52 to 136 basis
points per month, and the corresponding three-factor alpha increases from 49 to 138 basis points per
month. These return and alpha spreads are also highly significant without any exception. These results
are consistent with the illiquidity-based underreaction hypothesis that the market’s underreaction to
liquidity shocks is stronger for less liquid stocks.
The evidence thus far seems to be consistent with both the attention- and the illiquidity-based un-
derreaction hypotheses. One might argue that the attention proxies we employ (size, analyst coverage,
and institutional ownership) are highly correlated with the liquidity of a stock: Table 1, Panel B shows
that the average correlations between illiquidity (ILLIQ) and stock size (LNME), analyst coverage
(CVRG), and institutional ownership (INST) are −0.41, −0.26 and −0.24, respectively. Although
these correlations are not high in absolute terms, what the attention measures capture can potentially
be the effect of liquidity, and vice versa. To disentangle the effect of investor attention from illiquidity
and gauge the relative importance of the two mechanisms in contributing to markets’ underreaction
to liquidity shocks, we include both underreaction proxies and illiquidity as interaction variables with
LIQU in Fama-MacBeth regressions.
In Table 8, the cross-section of one-month ahead excess returns are regressed against the liquid-
ity shock proxies (LIQU, SPRDU, LIQCU), the illiquidity level (ILLIQ), the interaction between the
illiquidity level and liquidity shock, and the interaction between one attention proxy (LNME, CVRG,
INST) and liquidity shock, along with the same set of controls that are used in Table 6.
29

Panel A reports the Fama-MacBeth regression coefficients when liquidity shocks are measured by
LIQU.32 The results show that the average slope coefficient on (LIQU × AT T ENT ION) is negative
and highly significant across all three attention proxies (LNME, CVRG, and INST), suggesting that
the return predictability of liquidity shocks is stronger for low attention stocks, even after controlling
for any potential effect of illiquidity levels. The average slope on (LIQU × ILLIQ) is positive and
marginally significant when investor attention is proxied by LNME, but it is statistically insignificant
when investor attention is proxied by CVRG and INST. This suggests that illiquidity-driven slow price
adjustment may also be a contributing factor to markets’ underreaction to liquidity shocks although its
impact is weaker compared to the attention mechanism.
In Panel B of Table8, we use SPRDU as the proxy for liquidity shock and run the same set of cross-
sectional regressions with interaction variables. Similar to our earlier findings reported in Panel A, the
average slope coefficient on (SPRDU × AT T ENT ION) is negative and significant for both Models 1
and 2, across all three attention proxies. On the other hand, the average slope coefficient on (SPRDU ×
ILLIQ) is only positive and significant when investor attention is proxied by LNME, and insignificant
for the other two attention proxies.
In Panel C of Table 8, we use LIQCU as the proxy for liquidity shock. Similar to findings in Panels
A and B, the average slope coefficient on (LIQCU × AT T ENT ION) is negative and significant across
all three attention proxies, except in Model (1) when investor attention is proxied by CVRG. The co-
efficient on SPRDU × ILLIQ is positive and significant when size and institutional ownership are used
as attention proxies, but not when analyst coverage is used. The different level of significance of the
attention interaction variable and the illiquidity interaction variable suggests that these two interaction
variables are not capturing the same effect.
To summarize, the positive relation between liquidity shocks and one-month ahead stocks returns
remains significant for all specifications, and the relation is stronger for low attention stocks and for
32 We suppress the coefficient estimates of the cross-sectional controls. They are presented in Table A10 of the online
appendix.
30

illiquid stocks. The results imply that the positive relation between liquidity shocks and future returns
are due to markets’ underreaction to liquidity shocks, which can be attributed to investor inattention
and illiquidity.
Following Hong, Lim, and Stein (2000), and Hirshleifer, Lim, and Teoh (2009), we further inves-
tigate the attention and liquidity based mechanisms by studying long-term cumulative returns. Table 9
reports the Fama-MacBeth average slope coefficients on LIQU with and without the interaction terms,
and controlling for a large set of control variables listed earlier.33 Similar to Table 8, models (1) and
(2) use GKMH , GKML and VOLDU to capture abnormal dollar trading volume, respectively.
Panel A of Table 9 presents the benchmark model without interaction variables. It shows that,
consistent with Figure 1, the positive link between liquidity shocks and future cumulative stock returns
remains significant for at least six months into the future.
Panels B through D include attention and liquidity interaction variables. In Panel B of Table 9,
LNME proxies for investor attention. The average slope coefficient on (LIQU × LNME) is negative
and highly significant for six months into the future, indicating that the attention-based mechanism is
important for explaining return continuations over the next six months. On the other hand, the slope
coefficient on (LIQU × ILLIQ) becomes insignificant starting month 2, indicating that the illiquidity
driven underreaction is short-lived.
Panels C and D of Table 9 present qualitatively similar evidence when analysts’ coverage and
institutional ownership are used as proxies for investor attention. The average slope coefficient on
(LIQU × CV RG) is negative and highly significant up to five months into the future, and the average
slope coefficient on (LIQU × INST ) is negative and highly significant for two months into the future.
Overall, the results in Tables 8 and 9 suggest that, while inattention and illiquidity both contribute to
short term return predictability of liquidity shocks, the inattention based mechanism is more important
for the longer-run predictability. The regression results from long-term stock return prediction confirm
33 We obtain similar results when liquidity shocks are measured either with SPRDU or LIQCU, the results are shown in
Table A11 of the online appendix.
31

the portfolio results in Figure 1 and demonstrate that the horizon of return predictability is consistent
with other studies that document security market underreaction due to investor inattention (Bernard and
Thomas (1989), Hong, Lim, and Stein (2000) and Hirshleifer, Lim, and Teoh (2009)).
5. Robustness
In this section, we show that our results are robust to market microstructure effects, for different stock
exchanges, and during different subsample periods.
5.1. Market microstructure effects
Previously, we address the concern that our results may be driven by market microstructure effects such
as bid-ask bounce by controlling for past month returns, as well as various microstructure measures
(illiquidity, spreads, etc.). In this subsection, we provide an additional robustness check by measuring
liquidity shocks in month t − 2 and predicting the cross-section of stock returns in month t. In other
words, we skip a month between the liquidity shock estimation and the return prediction. Table 10
presents the average returns on the equal-weighted and value-weighted portfolios after skipping the
month. As shown in the last two rows of Table 10, the equal-weighted (value-weighted) raw return
differences and the corresponding alphas are, respectively, 0.60% and 0.70% (0.58% and 0.65%) per
month between the High- and Low-LIQU portfolios and significant at the 1% level based on the Newey-
West t-statistics. These positive and significant return and alpha spreads, together with the long-run
predictive regression results shown in Table 9, confirm that the predictive power of liquidity shocks
goes beyond the next month and is unlikely to be driven by short term microstructure effects.
In Section 3.3, we investigate one-month ahead predictive power of liquidity shocks after control-
ling for volume and volatility shocks using double sorted portfolios. We now test whether liquidity
shocks can continue to predict two-month ahead returns after controlling for volume and volatility
shocks, again with double sorted portfolios.
32

Panel B of Table 10 shows that after controlling for VOLDU, two-month ahead return (t + 2 return)
on LIQU portfolios averaged across the VOLDU quintiles increases from 0.99% to 1.49% per month,
with an average return difference of 50 basis points per month between Low and High LIQU portfolios,
and highly significant with a t-statistic of 5.01. The corresponding alpha is also 0.50% per month with
a t-statistic of 5.34. After controlling for IVOLU, t + 2 return on LIQU portfolios averaged across
the IVOLU quintiles increases monotonically from 0.91% to 1.53% per month, with an average return
difference of 62 basis points per month (t-statistic = 5.25). The corresponding alpha is 0.69% per
month, and highly significant with a t-statistic of 6.11. As shown in Table A12 of the online appendix,
similar results are obtained when we replicate Panel B of Table 10 by replacing LIQU with alternative
measures of liquidity shocks (SPRDU and LIQCU). These results suggest that the longer term return
predictability of liquidity shocks are robust with respect to volume shocks or volatility shocks.
To address the issue of bid-ask bounce more directly, we measure stock returns using the quoted
bid-ask midpoints and then replicate our main findings for the period of 1993-2010. The monthly stock
returns are calculated based on the quote midpoint, which is the average of the monthly closing national
best bid and offer (NBBO) and adjusted for dividends and stock splits.
In Table A13 of the online appendix, we report the equal- and value-weighted average one-month
ahead quote midpoint returns for decile portfolios formed on liquidity shocks. Panel A shows that
the average return differences between High and Low liquidity shock deciles and the corresponding
Fama-French alphas are positive and highly significant for all measures of liquidity shocks (LIQU,
SPRDU, and LIQCU). More importantly, both the economic and statistical significance of the return
and alpha spreads in Table A13 are very similar to those reported in Table 3. In addition to the portfolio
results in Panel A, we present stock-level cross-sectional regressions from midquote returns in Panel
B of Table A13. Panel B reports the average slope coefficients of liquidity shocks from the Fama-
MacBeth regressions of one-month ahead quote midpoint returns on liquidity shocks and all other
control variables. A notable point in Panel B is that both the magnitude and statistical significance
of the average slopes from quote midpoint returns are similar to those reported in Table 6. Overall,
33

these results indicate that the economically and statistically significant link between liquidity shocks
and future returns is not driven or magnified by microstructure effects.
We further account for the possibility that market microstructure effects can bias the Fama-MacBeth
regression coefficients using the technique of Asparouhova, Bessembinder, and Kalcheva (2010). Specif-
ically, we run monthly weighted least squares (WLS) regressions, where each observed return is
weighted by the gross return on the same stock in the prior month. For our key variable, liquidity
shocks, the coefficient estimates and t-statistics are slightly lower than our original results after cor-
recting for microstructure biases, but they all remain positive and significant at the 5% level or better.
The results are presented in Table A14 of the online appendix. It shows that the predictive power of
liquidity shocks is robust to potential microstructure-related biases.
5.2. Screen on stock exchanges
In this section, we provide evidence that our main findings are not driven by the inclusion of Amex and
Nasdaq stocks, and the results hold for big and liquid stocks in the S&P 500 sample.
We apply three types of screens by using stocks listed only on (i) NYSE/Amex, (ii) NYSE, and
(iii) S&P 500 index. Table 11 reports the one-month ahead returns of the univariate portfolios sorted
on LIQU for the three stock samples. The results show that the predictive ability of liquidity shocks
remains strong. The NYSE/Amex sample and the NYSE sample results are very similar to the full
CRSP sample result documented in Table 3, with the long-short portfolio raw return differential ranging
from 104 to 115 basis points per month for raw returns and 94 to 117 basis points per month for
three-factor adjusted returns, all highly significant. Even for the S&P 500 sample, the return and
alpha spreads from equal- and value-weighted portfolios remain economically large and statistically
significant, ranging from 61 to 68 basis points per month, suggesting that underreaction to liquidity
shocks is not restricted to small and illiquid stocks.
34

5.3. Recessionary vs. expansionary periods
In Table 12, we examine whether our findings are sensitive to the state of the economy by examining
the one-month ahead returns on the long-short portfolio sorted on LIQU for different subsample peri-
ods. The first two columns of Panel A exclude the most recent financial crisis period (July 2007 to June
2009). For this sample, the long-short portfolio generates a return of 121 basis points per month, com-
parable to the full sample results presented in Table 3. The next four columns present results for NBER
expansionary and recessionary periods, respectively. The raw returns from the long-short portfolio are
stable across the business cycles, with a magnitude of 116 basis points for the expansionary periods
and 130 basis points for the recessionary periods and statistically significant. The results suggest that
the predictive power of liquidity shocks are robust to different states of the economy.
5.4. Subsample analysis
In this section, we provide a thorough subsample analysis by dividing our full sample into five decades:
August 1963-July 1973, August 1973-July 1983, August 1983-July 1993, August 1993-July 2003, and
August 2003-December 2010.
Panel B of Table 12 shows that the average return differences and their alphas between the High and
Low LIQU portfolios are positive and highly significant for all decades. Specifically, the average raw
return differences are, respectively, 1.41%, 1.09%, 0.96%, 1.75%, and 0.55% per month for the afore-
mentioned decades, and are significant at the 5% level or better; the corresponding alpha differences
are, respectively, 1.32%, 0.95%, 0.96%, 1.88%, and 0.67% per month, and are all highly significant as
well. These results show that the strong positive link between liquidity shocks and future returns are
robust across different sample periods.
35

6. Discussions of Alternative Mechanisms
We have shown that the positive relation between liquidity shocks and future returns are robust after
controlling for a long list of alternative explanations, including the level and the variability of illiquidity,
the exposure to systematic liquidity risk, microstructure effects, and high volume return premium. In
this section, we discuss whether our findings can be explained by other mechanisms.
Hvidkjaer (2006, 2008) find that stocks with high level of sell-initiated small-trade volume tend to
outperform those with a high level of buy-initiated small-trade volume, suggesting that stocks favored
by retail investors experience overshooting in the short term which result in subsequent reversals. One
possibility is that stocks’ increased liquidity is driven by increased selling by retail investors, which
is followed by high returns in the subsequent months as the sells reverse out. This explanation is,
however, unlikely as the Hvidkjaer mechanism leads to return reversals (price overshooting), while we
observe return continuations (underreaction). To account for the effect of small trade order flows, we
follow Hvidkjaer (2008) and construct the signed small-trade turnover (SSTT) variable that is defined
as the small-trade buy-initiated turnover minus the small-trade sell-initiated turnover, measured over
the past one through 24 months.34 It turns out that the Hvidkjaer variables have a very low correlation
coefficient with our liquidity shock measures, ranging from -0.1% to -3.5%. We formally control for the
Hvidkjaer variables using bivariate portfolio sorts and by including them as additional control variables
in Fama-MacBeth regressions.
For month t, we sort common stocks into quintiles based on SSTTJ (J=1, 3, 6, 12 and 24); then
within each STTTJ quintile, we further sort stocks into quintile portfolios of liquidity shock.. Panel
A of Table 13 reports the one-month ahead returns and return differentials, averaged across the five
control groups for the same liquidity shock quintile. Panels A1, A2 and A3 correspond to liquidity
shock measures LIQU, SPRDU, and LIQCU, respectively. Our results show that, regardless of the
horizon used to measure SSTT, controlling for SSTT does not affect the economic magnitude or the
34 We provide a detailed description of the SSTT variables in the Appendix.
36

statistical significance of liquidity shocks’ predictive power for future returns. The return differences
between High and Low liquidity shock portfolios and their corresponding Fama-French alphas are in
the range of 77 and 129 basis points per month, and they are all significant at the 1% level.
We further run Fama-MacBeth predictive regressions of one-month ahead returns on liquidity shock
and SSTTJ , including all the other control variables listed in Table 6. Specifications (1) and (2) control
for the GKM dummy variables (GKMH and GKML ) and the abnormal dollar trading volume (VOLDU),
respectively. Panel B of Table 13 reports the average slope coefficients of liquidity shock and SSTT.35
The results indicate that the average slope coefficients of liquidity shock remain positive and highly
significant, and are similar in magnitude to those reported in Table 6. Consistent with Hvidkjaer (2008),
the average slope coefficients of SSTT are always negative and are mostly significant for aggregate
turnover over 3- to 12-month periods. Overall, the results of conditional bivariate sorts and Fama-
MacBeth cross-sectional regressions confirm that the predictive ability of liquidity shock is not driven
by the effect of the signed small-trade turnover.
One might argue that a liquidity shock can lead to a “flight to liquidity”, i.e., investors rush to dump
their illiquid stocks and shift their funds into the liquid ones. In this case, the assets with a negative
liquidity shock can be oversold and we should expect their prices to come back in the future. This
story can not explain why, on the contrary, we find that the prices of those that experienced a negative
liquidity shock continue to go down for an extended period of time in the future. Furthermore, “flight to
liquidity” usually occurs during a systematic market-wide liquidity crisis, while our findings are strong
and robust for all periods including busts and booms. Hence, our results cannot be explained by “flight
to liquidity”, although the evidence of return continuation after a liquidity shock do lend support to
investors’ motive to dump their less liquid assets and move to more liquid assets.
Some may argue that the story can go the other way: in a liquidity crisis, rather than flight to liquid-
ity, investors may choose to sell off liquid assets to meet margin constraints or capital requirements and
hold on to illiquid assets as they can only be sold at fire sale prices. As a result, stocks that are subject
35 For brevity, we suppress the average slope coefficients of the other control variables. They are available upon request.
37

to a positive liquidity shock (increases in liquidity) are oversold, and future returns should be positive
as they rebound. On the other hand, stocks that are subject to a negative liquidity shock (decreases in
liquidity) are not sold enough, and future returns should be negative as the prices of these assets come
down later. This story can produce a positive link between liquidity shocks and future stock returns
during crisis periods. However, it is not clear whether the effect should be there during normal peri-
ods. Given that our finding of a positive relation between liquidity shocks and future stock returns are
equally strong for non-crisis periods as well as recessionary and expansionary periods, it seems that the
proposed story cannot fully explain our findings.
Can the positive relation between liquidity shocks and future returns be driven by positively auto-
correlated liquidity shocks? That is, when negative liquidity shocks are followed by negative liquidity
shocks in the future, would this lead to lower future returns? The answer is no if the market is effi-
cient. If the market rationally and immediately reacts to liquidity shocks, it should have anticipated the
correlated nature of the shocks and should have factored it into prices, leaving no return predictability.
Thus, correlated liquidity shocks should not be able to predict future returns.
Generally speaking, if markets are rational and react to information promptly, these other value-
relevant shocks (information releases and company events) should have been incorporated into prices
already and any of their predictability should have been captured by the predictability of past returns.
Our results remain significant after controlling for past returns and past earnings surprises, suggesting
that these other factors alone can not explain our findings. For future work, it might be interesting to
focus on concrete cases of liquidity shocks and study market’s reactions to these particular episodes in
an event study setting. One example of such events is stock splits. Muscarella and Vetsuypens (1996),
Schultz (2000) and Lin, Singh, and Yu (2009) find that there has been considerable increases in trading
volume and reduction in liquidity risk subsequent to stock splits. This suggests that stock splits increase
the liquidity of the stocks and should lead to a reduction in risk premia. The implication is that, in a
fully efficient market in which investors react immediately and rationally to split announcements, share
prices should rise instantaneously and future returns should be low. However, this is inconsistent with
38

the findings in Ikenberry, Rankine, and Stice (1996) and Desai and Jain (1997), who document that
prices continue to drift upwards up to one year following split announcements. Investigating stock
market’s underreaction to stock splits and the associated liquidity changes can potentially explain these
findings.
Another interesting question for future analysis is what is the exact propagation mechanism of
the securities markets’ underreaction to liquidity shocks. Given that securities dealers (or designated
market makers) are liquidity providers, why wouldn’t they be able to react promptly to liquidity shocks
by changing their quotes? The reasons can be the following.
First, dealers face incomplete information and rely on information extracted from order flows,
which aggregates information from the marginal investor of a stock. A large body of empirical evidence
shows that investor inattention has significant pricing impacts, suggesting that attention constraint is
binding for the marginal investors of a considerable number of stocks. If the marginal investor can not
fully process all available information (including information about changes in future liquidity and its
impact on prices), the amount of information the dealer can learn from order flows will be limited. As
a result, the prices that the dealer sets would not fully reflect information on liquidity shocks.
Second, there are empirical evidence that even dealer themselves are subject to limited attention.
Corwin and Coughenour (2008) show that NYSE specialists’ attention constraints affect execution
quality in terms of price improvement and transaction costs for securities for which they are market
makers, and as a result, stocks that receives less specialist attention exhibit less frequent price improve-
ments. Boulatov et al. (2009) find that the speed of quote adjustment is faster for stocks with greater
attention from NYSE specialists. Chakrabarty and Moulton (2012) find that attention constraints for
NYSE specialists have an effect on the liquidity of the stocks they handle. These articles suggest that
one potential propagation mechanism of markets’ underreaction to liquidity shocks is because securi-
ties dealers suffer from limited attention.
39

For future work, it would be interesting to explore how order flow and dealers’ quoting behavior
respond to liquidity shocks and how dealers’ attention allocation across stocks in their portfolio affect
the speed of quote adjustments in response to liquidity shocks.
7. Conclusion
The liquidity of a stock refers to the degree to which a significant quantity can be traded in a short period
without incurring a large transaction cost or adverse price impact. Given that the level of individual
stock illiquidity is positively priced in the cross-section of expected returns and that liquidity shocks
have persistent effects, one would expect that negative liquidity shocks lead to higher future returns if
stock market reacts immediately and to the full extent to the increased risk premium.
On the contrary, we find a surprising positive relation between stock level liquidity shocks and
future returns: decile portfolios that long stocks with positive liquidity shocks and short stocks with
negative liquidity shocks generate a raw and risk-adjusted return of 0.70% to 1.20% per month. This
relation is economically and statistically significant and robust across alternative measures of liquid-
ity shocks and after controlling for various risk factors and stock characteristics such as beta, size,
book-to-market, momentum, short-term reversal, co-skewness, idiosyncratic volatility, maximum daily
return, analyst dispersion, level and volatility of illiquidity, exposures to systematic liquidity factors,
unexpected earnings, abnormal dollar trading volume, and signed small-trade turnover. The strong
predictive power of liquidity shocks remains intact for various subsample periods, as well as across
recessionary and expansionary periods.
We show that negative liquidity shocks not only lead to lower contemporaneous returns, but they
also continue to predict negative returns for up to seven months in the future. This evidence suggests
that the stock market underreacts to stock level liquidity shocks.
We explore two potential driving forces of this underreaction: investor inattention and illiquidity.
We find that the predictive power of liquidity shocks for future returns is stronger among stocks that
40

receive less investor attention (small stocks and stocks with low analyst coverage and institutional
holdings) as well as among less liquid stocks. While both mechanisms are significant in explaining
one-month ahead return predictability of liquidity shocks, investor inattention mechanism is stronger
in predicting two- to four-month ahead returns.
Our study contributes to the empirical literature on the effects of investor inattention on stock price
dynamics by introducing a new liquidity dimension. Our findings also contribute to the literature on
liquidity and stock returns by focusing on time series variations in liquidity and by providing the first
piece of evidence on the stock market’s underreaction to stock level liquidity shocks.
41

References
Acharya, V., and L. H. Pedersen, 2005, “Asset Pricing with Liquidity Risk,” Journal of Financial
Economics, 77, 375–410.
Akbas, F., W. J. Armstrong, and R. Petkova, 2010, “The Volatility of Liquidity and Expected Stock
Returns,” Working Paper.
Amihud, Y., 2002, “Illiquidity and Stock Returns: Cross-section and Time-Series Effects,” Journal of
Financial Markets, 5, 31–56.
Amihud, Y., and H. Mendelson, 1986, “Asset Pricing and the bid-ask spread,” Journal of Financial
Economics, 17, 223–249.
, 1989, “The Effects of Beta, Bid-Ask Spread, Residual Risk and Size on Stock Returns,”
Journal of Finance, 44, 479–486.
An, B.-J., A. Ang, T. G. Bali, and N. Cakici, 2013, “The Joint Cross Section of Stocks and Options,”
Journal of Finance, forthcoming.
Ang, A., R. Hodrick, Y. Xing, and X. Zhang, 2006, “The cross-section of volatility and expected
returns,” Journal of Finance, 61, 259–299.
, 2009, “High idiosyncratic volatility and low returns: International and further U.S. evidence,”
Journal of Financial Economics, 91, 1–23.
Asparouhova, E. N., H. Bessembinder, and I. Kalcheva, 2010, “Liquidity Biases in Asset Pricing Tests,”
Bali, T. G., N. Cakici, and R. Whitelaw, 2011, “Maxing out: Stocks as lotteries and the cross-section
of expected returns,” Journal of Financial Economics, 99, 427–446.
Bali, T. G., A. Scherbina, and Y. Tang, 2009, “Unusual News Events and the Cross-Section of Stock
Returns,” Working Paper.
Ball, R., and P. Brown, 1968, “An empirical evaluation of accounting income numbers,” Journal of
Accounting Research, 6, 159–178.
Barber, B., and T. Odean, 2008, “All that glitters: The effect of attention on the buying behavior of
individual and institutional investors,” Review of Financial Studies, 21, 785–818.
Bekaert, G., and G. Wu, 2000, “Asymmetric Volatility and Risk in Equity Markets,” Review of Financial
Studies, 13, 1–42.
Bernard, V. L., and J. K. Thomas, 1989, “Post-Earnings-Announcement Drift: Delayed Price Response
or Risk Premium,” Journal of Accounting Research, 27, 1–36.
, 1990, “Evidence that stock prices do not fully reflect the implications of current earnings for
future earnings,” Journal of Accounting and Economics, 13, 305–340.
Bessembinder, H., and K. Venkataraman, 2010, “Bid-Ask Spreads: Measuring Trade Execution Costs
in Financial Markets,” Encyclopedia of Quantitative Finance.
Black, F., 1976, “The pricing of commodity contracts,” Journal of Financial Economics, 3, 167–179.
Bollerslev, T., J. Litvinova, and G. Tauchen, 2006, “Leverage and Volatility Feedback Effects in High-
Frequency Data,” Journal of Financial Econometrics, 4, 353–384.
42

Boulatov, A., S. A. Johnson, B. C. Hatch, and Y. C. Lei, 2009, “Dealer attention, the speed of quote
adjustments to information, and net dealer revenue,” Journal of Banking and Finance, 33, 1531–
1542.
Brennan, M. J., T. Chordia, and A. Subrahmanyam, 1998, “Alternative Factor Specifications, Security
Characteristics, adn the Cross-Section of Expected Stock Returns,” Journal of Financial Economics,
49, 345–373.
Brennan, M. J., N. Jegadeesh, and B. Swaminathan, 1993, “Investment Analysis and the Adjustment of
Stock Prices to Common Information,” Review of Financial Studies, 6, 799–824.
Brennan, M. J., and A. Subrahmanyam, 1996, “Market microstructure and asset pricing: On the com-
pensation for illiquidity in stock returns,” Journal of Financial Economics, 41, 441–464.
Campbell, J. Y., and L. Hentschel, 1992, “No news is good news: An asymmetric model of changing
volatility in stock returns,” Journal of Financial Economics, 31, 281–318.
Chakrabarty, B., and P. C. Moulton, 2012, “Earnings announcement and attention constraints: The role
of market design,” Journal of Accounting and Economics, 53, 612–634.
Chordia, T., S. Huh, and A. Subrahmanyam, 2009, “Theory-based Illiquidity and Asset Pricing,” Re-
view of Financial Studies, 22, 3629–2668.
Chordia, T., R. Roll, and A. Subrahmanyam, 2000, “Commonality in liquidity,” Journal of Financial
Economics, 56, 3–28.
, 2001, “Market Liquidity and Trading Activity,” Journal of Finance, 56, 501–530.
Chordia, T., A. Subrahmanyam, and V. R. Anshuman, 2001, “Trading Activity and Expected Stock
Returns,” Journal of Financial Economics, 59, 3–32.
Christie, A. A., 1982, “The stochastic behavior of common stock variances: Value, leverage and interest
rate effects,” Journal of Financial Economics, 10, 407–432.
Cohen, L., and A. Frazzini, 2008, “Economic Links and Predictable Returns,” Journal of Finance, 63,
1977–2011.
Constantinides, G., 1986, “Capital Market Equilibrium with Transaction Costs,” Journal of Political
Economy, 94, 842–862.
Corwin, S. A., and J. F. Coughenour, 2008, “Limited attention and the allocation of effort in securities
trading,” Journal of Finance, 63, 3031–3067.
Cremers, M., and V. Nair, 2005, “Governance Mechanisms and Equity Prices,” Journal of Finance, 60,
2859–2894.
Datar, V. S., N. Y. Naik, and R. Radcliffe, 1998, “Liquidity and Asset Returns: An Alternative Test,”
Journal of Financial Markets, 1, 203–219.
DellaVigna, S., and J. Pollett, 2007, “Demographics and Industry Returns,” American Economic Re-
view, 97, 1167–1702.
, 2009, “Investor Inattention and Friday Earnings Announcements,” Journal of Finance, 64,
709–749.
Desai, H., and P. Jain, 1997, “Long-run Common Stock Returns Following Stock Splits and Reverse
Splits,” Journal of Business, 70, 409–433.
43

Diether, K., C. Malloy, and A. Scherbina, 2002, “Differences of opinion and the cross-section of stock
returns,” Journal of Finance, 57, 2113–2141.
Duffie, D., N. Garleanu, and L. H. Pedersen, 2002, “Securities Lending, Shorting, and Pricing,” Journal
of Financial Economics, 66, 307–339.
, 2005, “Over-the-Counter Markets,” Econometrica, 73, 1815–1847.
Eleswarapu, V. R., 1997, “Cost of Transacting and Expected Returns in the Nasdaq Market,” Journal
of Finance, 52, 2113–2117.
Fama, E. F., and K. R. French, 1992, “The cross-section of expected stock returns,” Journal of Finance,
46, 427–466.
, 1993, “Common risk factors in the returns of stocks and bonds,” Journal of Financial Eco-
nomics, 33, 3–56.
, 2000, “Characteristics, covariances, and average returns: 1929-1997,” Journal of Finance, 55,
389–406.
Fama, E. F., and J. MacBeth, 1973, “Risk, return and equilibrium: Empirical tests,” Journal of Political
Economy, 51, 55–84.
French, K. R., G. W. Schwert, and R. F. Stambaugh, 1987, “Expected stock returns and volatility,”
Gao, X., and J. R. Ritter, 2010, “The Marketing of Seasoned Equity Offerings,” Journal of Financial
Economics, 97, 33–52.
Garleanu, N., and L. H. Pedersen, 2004, “Adverse Selection and the Required Return,” Review of
Financial Studies, 17, 643–665.
Gervais, S., R. Kaniel, and D. Mingelgrin, 2001, “The high-volume return premium,” Journal of Fi-
nance, 56, 877–919.
Harvey, C. R., and A. Siddique, 2000, “Conditional skewness in asset pricing tests,” Journal of Finance,
55, 1263–1295.
Hasbrouck, J., 2009, “Trading Costs and Returns for US Equity,” Journal of Finance, 63, 1445–1477.
Hasbrouck, J., and D. J. Seppi, 2001, “Common factors in prices, order flows, and liquidity,” Journal
Heaton, J., and D. J. Lucas, 1996, “Evaluating the Effects of Incomplete Markets on Risk Sharing and
Asset Pricing,” Journal of Political Economy, 104, 443–487.
Hirshleifer, D., K. Hou, S. H. Teoh, and Y. Zhang, 2004, “Do Investors Overvalue Firms with Bloated
Balance Sheets,” Journal of Accounting and Economics, 38, 297–331.
Hirshleifer, D., P.-H. Hsu, and D. Li, 2012, “Innovative Efficiency and Stock Returns,” Journal of
Financial Economics, forthcoming.
Hirshleifer, D., S. Lim, and S. H. Teoh, 2009, “Driven to Distraction: Extraneous Events and Underre-
action to Earnings News,” Journal of Finance, 64, 2289–2325.
Hirshleifer, D., and S. H. Teoh, 2003, “Limited Attention, Information Disclosure, and Financial Re-
porting,” Journal of Accounting and Economics, 36, 337–386.
44

Hodrick, R., 1992, “Dividend Yields and Expected Stock Returns: Alternative Procedures for Inference
and Measurement,” Review of Financial Studies, 5, 357–386.
Hong, H., T. Lim, and J. Stein, 2000, “Bad news travels slowly: Size, analyst coverage, and the prof-
itability of momentum strategies,” Journal of Finance, 55, 265–295.
Hong, H., W. Torous, and R. Valkanov, 2007, “Do Industries Lead the Stock Market?,” Journal of
Financial Economics, 83, 367–396.
Hou, K., 2007, “Industry Information Diffusion and the Lead-Lag Effect in Stock Returns,” Review of
Hou, K., and T. Moskowitz, 2005, “Market Frictions, Price Delay, and the Cross-Section of Expected
Returns,” Review of Financial Studies, 18, 981–1020.
Huang, M., 2003, “Liquidity Shocks and Equilibrium Liquidity Premia,” Journal of Economic Theory,
109, 104–129.
Huberman, G., and D. Halka, 2001, “Systematic Liquidity,” Journal of Financial Research, 2, 161–178.
Huberman, G., and T. Regev, 2001, “Contagious Speculation and a Cure for Cancer: A Non-Event
That Made Stock Prices Soar,” Journal of Finance, 56, 387–396.
Hvidkjaer, S., 2006, “A Trade-based Analysis of Momentum,” Review of Financial Studies, 19, 457–
491.
, 2008, “Small trades and the cross-section of stock returns,” Review of Financial Studies, 21,
1123–1151.
Ikenberry, D. L., G. Rankine, and E. K. Stice, 1996, “What Do Stock Splits Really Signal?,” Journal
of Financial and Quantitative Analysis, 31, 357–375.
Jegadeesh, N., 1990, “Evidence of predictable behavior of security returns,” Journal of Finance, 45,
881–898.
Jegadeesh, N., and S. Titman, 1993, “Returns to buying winners and selling losers: Implications for
stock market efficiency,” Journal of Finance, 48, 65–91.
Jones, C. M., 2002, “A Century of Stock Market Liquidity and Trading Costs,” Working Paper,
Columbia University.
Kahneman, N., 1973, Attention and effort. Prentice Hall, New Jersey.
Kyle, A. S., 1985, “Continuous auctions and insider trading,” Econometrica, 53, 1315–1335.
Lee, C. M. C., and M. J. Ready, 1991, “Inferring trade direction from intraday data,” Journal of Fi-
nance, 46, 733–746.
Lin, J.-C., A. K. Singh, and W. Yu, 2009, “Stock Splits, Trading Continuity, and the Cost of Equity
Capital,” Journal of Financial Economics, 93, 474–489.
Lo, A. W., H. Mamaysky, and J. Wang, 2004, “Asset Prices and Trading Volume Under Fixed Transac-
tions,” Journal of Political Economy, 112, 1054–1090.
Mashruwala, C., S. Rajgopal, and T. Shevlin, 2006, “Why Is the Accrual Anomaly Not Arbitraged
Away? The Role of Idiosyncratic Risk and Transaction Costs,” Journal of Accounting and Eco-
nomics, 42, 3–33.
45

Muscarella, C. J., and M. R. Vetsuypens, 1996, “Stock splits: Signaling or liquidity? The case of ADR
’solo-splits’,” Journal of Financial Economics, 42, 3–26.
Nelson, D. B., 1991, “Conditional heteriskedasticity in asset returns: A new approach,” Econometrica,
59, 347–370.
Newey, W. K., and K. D. West, 1987, “A simple, positive-definite, heteroscedasticity and autocorrela-
tion consistent covariance matrix,” Econometrica, 55, 703–708.
Pashler, H., and J. Johnston, 1998, “Attentional Limitations in Dual-task performance,” in Attention,
ed. by H. Pashler. Psychology Press, pp. 155–189.
Pastor, L., and R. F. Stambaugh, 2003, “Liquidity Risk and Expected Stock Returns,” Journal of Polit-
ical Economy, 111, 642–685.
Peng, L., 2005, “Learning with Information Capacity Constraints,” Journal of Financial Quantitative
Analysis, 40, 307–329.
Peng, L., and W. Xiong, 2006, “Investor Attention, Overconfidence and Category Learning,” Journal
Pereira, J. P., and H. H. Zhang, 2010, “Stock Returns and the Volatility of Liquidity,” Journal of Finan-
cial Quantitative Analysis, 45, 1077–1110.
Sadka, R., 2006, “Momentum and post-earnings-announcement drift anomalies: The role of liquidity
risk,” Journal of Financial Economics, 80, 309–349.
Schultz, P., 2000, “Stock Splits, Tick Size, and Sponsorship,” Journal of Finance, 55, 429–450.
Shumway, T., 1997, “The delisting bias in CRSP data,” Journal of Finance, 52, 327–340.
Vayanos, D., 1998, “Transaction Costs and Asset Prices: A Dynamic Equilibrium Model,” Review of
Appendix
This appendix provides detailed descriptions on how we construct our control variables. Unless other-
wise stated, we measure all variables at the end of portfolio formation month (i.e., month t) and require
a minimum of 15 daily observations for all variables computed monthly from daily data.
Following Fama and French (1992), market beta of an individual stock is estimated by running a
time-series regression based on the monthly return observations over the prior 60 months if available
(minimum of 24 months):
Ri,t − R f ,t = αi + β1i (Rm,t − R f ,t ) + β2i (Rm,t−1 − R f ,t−1 ) + εi,t , (1)
where Ri , R f , and Rm are the monthly returns on stock i, the one-month Treasury bills, and the CRSP
value-weighted index, respectively. The stock’s market beta is the sum of the slope coefficients of the
current and lagged excess market returns (i.e. BETA= βb1i + βb2i ).
The stock’s size (LNME) is the natural logarithm of the product of the price per share and the
number of shares outstanding (in million dollars). Following Fama and French (1992, 1993, and 2000),
the natural logarithm of the book-to-market equity ratio at the end of June of year t, denoted LNBM,
46

is computed as the book value of stockholders’ equity, plus deferred taxes and investment tax credit
(if available), minus the book value of preferred stock for the last fiscal year end in t − 1, scaled by
the market value of equity at end of December of t − 1. Depending on availability, the redemption,
liquidation, or par value (in that order) is used as the book value of preferred stock.
Following Jegadeesh and Titman (1993), momentum (MOM) is the cumulative return of a stock
over a period of 11 months ending one month prior to the portfolio formation month. Following Je-
gadeesh (1990), short-term reversal (REV) is defined as the stock return over the prior month.
Following Harvey and Siddique (2000), the stock’s monthly co-skewness (COSKEW) is defined
as the estimate of γi in the regression using the monthly return observations over the prior 60 months
(minimum of 24 months):
Ri,t − R f ,t = αi + βi (Rm,t − R f ,t ) + γi (Rm,t − R f ,t )2 + εi,t , (2)

where Ri , R f , and Rm are the monthly returns on stock i, the one-month Treasury bills, and the CRSP
value-weighted index, respectively.
Following Ang, Hodrick, Xing, and Zhang (2006), the monthly idiosyncratic volatility of stock i
(IVOL) is computed as the standard deviation of the residuals from the regression:

Ri,d − R f ,d = αi + βi Rm,d − R f ,d + γi SMBd + ϕi HMLd + εi,d , (3)
where Ri,d , R f ,d , and Rm,d are, respectively, the daily returns on stock i, the one-month Treasury bills,
and the CRSP value-weighted index. SMBd and HMLd are the daily size and book-to-market factors
of Fama and French (1993).
Following Bali, Cakici, and Whitelaw (2011), the stock’s extreme positive return (MAX) is defined
as its maximum daily return in each month.
Following Diether, Malloy, and Scherbina (2002), analyst earnings forecast dispersion (DISP) is the
standard deviation of annual earnings-per-share forecasts scaled by the absolute value of the average
outstanding forecast.
Stocks that experience positive (negative) liquidity shocks may coincide with positive (negative)
earnings shocks and it is well known that earnings shocks are followed by a post announcement drift.
To control for this effect, we follow Ball and Brown (1968) and Bernard and Thomas (1989, 1990) and
define stock i’s unexpected EPS (UE) in calendar quarter q of earnings announcement as:
UEi,q = EPSi,q − EPSi,q−4 , (4)

where EPSi,q and EPSi,q−4 are the stock’s basic EPS excluding extraordinary items in quarters q and
q − 4, respectively. The stock’s standardized unexpected earnings in quarter q (SUEq ) is UEq scaled by
its standard deviation over the past eight quarters (with a minimum of four UE observations available).
Since a stock’s liquidity and trading volume are highly related, we also examine whether the pricing
effect of liquidity shocks is driven by the high volume return premium documented by Gervais, Kaniel,
and Mingelgrin (2001). Following Gervais et al. (2001), stocks are first sorted into low, normal, and
high volume portfolios based on the dollar trading volume on the last but second trading day in the
portfolio formation month relative to daily dollar trading volume over the prior 49 trading days. We
then create two volume premium dummy variables: the high-volume dummy variable (GKMH ) is 1
if a stock belongs to the high volume group and zero otherwise; the low-volume dummy variable
(GKML ) equal to 1 if a stock resides in the low volume portfolio and zero otherwise. Hence, stock i
in month t belongs to one the three groups: GKMH , GKML , and GKMM indicating that the stock does
not experience abnormally high or low dollar volume. We further construct a continuous variable for
47

abnormal dollar volume (VOLDU) in the same fashion as we define the liquidity shock. That is, we
subtract monthly dollar volume by its past 12-month average.
We also control for a variety of liquidity-based variables. Following Chordia, Subrahmanyam, and
Anshuman (2001), the trading activity (SDTURN) is computed as the standard deviation of monthly
turnover (TURN) over the past 12 months. Following Akbas, Armstrong, and Petkova (2010), the
coefficient of variation in the Amihud illiquidity (CVILLIQ) is computed as the standard deviation of
the daily Amihud’s illiquidity measure in a month scaled by the monthly Amihud’s illiquidity measure.
Following Pastor and Stambaugh (2003), the stock’s liquidity exposure (PS) is the OLS estimate of
βLi in the regression, estimated using all data available over the past 60 months (if at least 24 months
are available):
Ri,t − R f ,t = αi + βLi Lt + βM S H
i MKTt + βi SMBt + βi HMLt + εi,t , (5)
where Ri and R f are the monthly returns on stock i and the one-month Treasury bills, respectively. L
is the innovation in aggregate liquidity factor, and MKT , SMB, and HML are the three factors of Fama
and French (1993).
Following Acharya and Pedersen (2005) at the end of year k − 1, we sort common stocks listed
on NYSE, Amex and Nasdaq into 25 groups based on the average daily Amihud’s (2002) illiquidity
ratio in year k − 1 (with at least 100 daily ratios available) using the NYSE illiquidity breakpoints. We
estimate the four betas proposed in Acharya and Pedersen (2005) that capture different aspects of a
security’s systematic risk in a world where trading costs vary randomly over time:
Cov (r p,t , rm,t )
β1p = , (6)
Var (rm,t − cum,t )
Cov (cu p,t , cum,t )
β2p = , (7)
Cov (r p,t , cum,t )
β3p = , (8)
Cov (cu p,t , rmm,t )
β4p = , (9)
where r p and rm are, respectively, the monthly excess returns for portfolio p and the market portfolio
proxied by the CRSP equal-weighted index; cu p and cum are the monthly innovations in illiquidity for
portfolio p and the market, respectively. For each month t, we normalize the monthly Amihud’s (2002)
illiquidity measures in months t to t − 2 for stock i (denoted ci,t , ci,t−1|t and ci,t−2|t , respectively) by
ci,t = min (0.25 + 0.3ILLIQi,t Pm,t−1 , 30) , (10)

ci,t−1 = min (0.25 + 0.3ILLIQi,t−1 Pm,t−1 , 30) , (11)
ci,t−2 = min (0.25 + 0.3ILLIQi,t−2 Pm,t−1 , 30) , (12)
where Pm,t−1 is the ratio of the capitalization of the market portfolio at the end of month t − 1 to that
as of the end of July 1962. We then calculate the illiquidity measures in months t to t − 2 for each
48

illiquidity portfolio (denoted c p,t , c p,t−1|t and c p,t−2|t , respectively) by averaging the corresponding
normalized illiquidity measures for each stock in the portfolio:
1 T
c p,t = ∑ ci,t , (13)
N t=1
1 T
c p,t−1|t = ∑ ci,t−1|t , (14)
N t=1
1 T
c p,t−2|t = ∑ ci,t−2|t . (15)
N t=1
The illiquidity measures in months t to t − 2 for the market (denoted cm,t , cm,t−1|t and cm,t−2|t , re-
spectively) are calculated similarly by averaging the corresponding normalized illiquidity measures for
NYSE/Amex common stocks.
The liquidity innovations in month t for portfolio p (cu p,t ) and the market (cm p,t ) are defined as
the residuals of the AR(2) model estimated based on a 60-month rolling sample with a minimum of 24
observations and updated on a monthly basis:
c p/m,t = a0 + a1 c p/m,t−1|t + a2 c p/m,t−2|t + ε p/m,t , (16)

cu p/m,t ≡ ε p/m,t . (17)
For each month t, the four factor loadings of stock i (denoted β1i,t , β2i,t , β3i,t and β4i,t ) are, respectively, set
to β1p,t , β2p,t , β3p,t and β4p,t of the illiquidity portfolio to which the stock belongs in the month.
We further control for the pricing effects of the illiquidity risk factor of Sadka (2006). We download
from Ronnie Sadka’s webpage the time series of the monthly fixed and variable components of the
illiquidity factor covering the period from April 1984 to December 2010. For each month, a stock’s
illiquidity risk loadings on the fixed and the variable components (denoted SADKAF and SADKAV,
respectively) are estimated using monthly return data over the prior 60 months with a minimum of
24 monthly observations available after controlling for the monthly market, size and book-to-market
factors of Fama and French (1993):
Ri,t − R f ,t = αi + λ1 FIXt + λ2VARt + βi (Rm,t − R f ,t ) + γi SMBt + ϕi HMLt + εi,t , (18)

where FIX and VAR are the fixed and variable components of Sadka’s liquidity factor.
In Section 4, we investigate the pricing effect associated with liquidity shocks in conjunction with
alternative measures of investor attention. Following the literature, we use several measures to capture
the degree of investor attention: (i) stock size (LNME); (ii) analyst coverage (CVRG), computed as
the natural logarithm of the number of analysts covering the stock in the portfolio formation month;
and (iii) institutional holdings (INST), defined as quarterly institutional ownership as of the portfolio
formation month.
In Section 6, to ensure that our liquidity shock measures are not picking up the effect of small
trade order flows, we control for the variables originally introduced by Hvidkjaer (2008). Each trade
from the TAQ database covering the period of 1993 - 2010 is identified as buy- or sell-initiated using
the procedure described in Lee and Ready (1991). We sort stocks into quintile portfolios based on the
NYSE/Amex size breakpoints. The small-trade cutoff for each size quintile is calculated as the ratio of
a dollar cutoff to the share price at the end of the prior month rounded up to the nearest hundred round-
lot, where the dollar cutoffs are, respectively, $4,800, $7,300, $10,300 and $16,400 for the smallest to
the largest size portfolios. The monthly small-trade buy-initiated turnover is calculated as the ratio of
49

the small-trade buy-volume in a month to the number of shares outstanding. The monthly small-trade
sell-initiated turnover is calculated similarly. At the end of each portfolio formation month (i.e., month
t), the small-trade buy- and sell-initiated turnover are then summed over the prior J months, where
J=1, 3, 6, 12, and 24. For each J, the signed small-trade turnover (SSTTJ ) is the difference between
the corresponding summed small-trade buy-initiated turnover and the summed small-trade sell-initiated
turnover.
50

Figure 1. Monthly return differences between the highest and lowest LIQU deciles for 1 to 12
months after portfolio formation. This figure depicts the monthly return differences between the
highest and lowest LIQU deciles for 1 to 12 months after portfolio formation. LIQU is the liquidity
shock, defined as the negative Amihud’s (2002) illiquidity measure (ILLIQ), demeaned using the past
12-month ILLIQ as the mean. The dashed lines indicate the 95% confidence bands based on the
Newey-West robust standard errors.
51

Table 1
Descriptive statistics
Panel A reports the time-series averages of the cross-sectional mean, median, and standard deviation
of each variable used in this paper. All the variables, except for RET, the return in month t + 1, are
computed for individual stocks at the end of the portfolio formation month (month t). LIQU denotes
the liquidity shock, defined as the negative Amihud’s (2002) illiquidity measure (ILLIQ), demeaned
using the past 12-month ILLIQ as the mean. SPRDU is the shock to the monthly volume-weighted
effective relative spread (SPRD), calculated in the same fashion as LIQU. LIQCU denotes the condi-
tional measure of liquidity shock, defined as the negative of the difference between the realized ILLIQ
and the conditional mean of ILLIQ in the month estimated under the assumption that the conditional
mean of ILLIQ follows an ARMA(1,1) process. BETA, LNME, and LNBM denote the market beta,
the natural logarithm of the market capitalization, and the natural logarithm of the book-to-market eq-
uity ratio, respectively. MOM is the momentum return. REV is the short-term reversal. COSKEW
and IVOL are the co-skewness and idiosyncratic volatility, respectively. MAX denotes the maximum
daily return in a month. DISP measures the analyst earnings forecast dispersion. SUE is the stan-
dardized unexpected earnings. GKMH and GKML denote the high- and low-volume dummy variables.
VOLDU is the dollar trading volume shock, calculated in the same fashion as LIQU and SPRDU. SD-
TURN denotes the standard deviation of the monthly turnover over the past 12 months. CVILLIQ is
the coefficient of variation in the Amihud’s illiquidity measure. PS is Pastor and Stambaugh’s (2003)
liquidity beta. BETA1–BETA4 are Acharya and Pedersen’s (2005) four liquidity betas. SADKAF and
SADKAV are the loadings on the fixed and the variable components of Sadka’s (2006) liquidity fac-
tor. CVRG denotes the natural logarithm of the number of analysts covering the stock. INST is the
quarterly institutional ownership. Panel B reports time-series average of the monthly cross-sectional
correlations (multiplied by 100) between the variables in our sample. The full sample covers the period
from August 1963 to December 2010.
52

Table 1 – continued
Panel A. Summary statistics
Variable Mean Median Std. dev.
RET 1.12 0.51 11.08
ILLIQ 0.81 0.15 2.94
SPRD 0.99 0.70 0.98
LIQU 0.17 0.01 1.39
SPRDU 0.27 0.07 1.02
LIQCU 0.26 0.01 3.07
BETA 1.32 1.21 0.79
LNME 5.34 5.17 1.63
LNBM -0.50 -0.41 0.74
MOM 20.18 10.92 53.19
REV 1.77 0.79 11.74
COSKEW -0.01 -0.01 0.08
IVOL 2.12 1.85 1.25
MAX 5.73 4.66 4.50
DISP 0.13 0.02 0.90
SUE -0.02 -0.01 1.04
GKMH 0.11 0.03 0.27
GKML 0.08 0.00 0.27
VOLDU 0.43 -0.08 3.03
CVILLIQ 1.14 1.03 0.44
SDTURN 0.42 0.24 0.73
PS -1.20 -0.82 36.10
BETA1 0.93 0.83 1.62
BETA2 0.01 0.00 0.14
BETA3 -0.03 -0.03 0.89
BETA4 -0.02 0.00 0.28
SADKAF 2.44 0.71 35.61
SADKAV -0.25 -0.15 6.16
CVRG 1.89 1.89 0.77
INST 0.43 0.44 0.24
53

Panel B: Correlations
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) (18) (19) (20) (21) (22) (23) (24) (25) (26) (27) (28) (29)
RET (1)
ILLIQ (2) 0.2
SPRD (3) 0.1 53.4
LIQU (4) 2.4 -19.3 15.4
SPRDU (5) 2.0 -6.4 -15.9 42.8
LIQCU (6) 1.7 -15.3 10.0 52.8 21.4
BETA (7) -0.9 4.0 3.9 3.4 7.5 6.6
LNME (8) -0.6 -40.8 -65.3 -12.6 -11.6 -12.5 -22.1
LNBM (9) 2.6 13.4 14.2 3.5 -1.4 -0.9 -13.0 -22.5
MOM (10) 3.5 -7.8 -6.2 22.5 27.0 13.8 5.1 2.5 -14.1
REV (11) -3.0 -0.5 2.1 12.6 11.9 9.9 1.7 0.1 2.0 0.4
COSKEW (12) -0.2 -4.1 -10.3 -1.7 -2.2 -2.4 3.7 10.2 4.2 -1.1 0.2
IVOL (13) -3.7 25.3 39.9 9.8 6.5 12.1 34.2 -41.0 -6.0 1.8 21.2 -4.2
MAX (14) -3.6 16.2 26.6 11.6 8.3 12.2 28.8 -28.8 -4.8 1.2 42.0 -2.8 85.8
54
DISP (15) -1.0 -2.7 -0.1 -2.1 -1.1 -1.7 4.0 1.3 3.3 -5.3 -0.8 0.7 3.8 3.1
SUE (16) 3.8 -1.1 -2.4 6.8 7.6 1.8 -0.5 3.0 -0.6 23.1 8.5 0.3 -1.3 1.3 -2.3
GKMH (17) 0.5 2.6 5.6 -7.3 -11.0 -3.5 -0.3 -5.0 1.1 -20.7 -28.2 -0.2 4.7 -4.6 2.9 -12.8
GKML (18) 0.2 -0.8 -1.3 2.7 3.1 0.8 -0.8 1.3 -0.7 8.7 -1.1 0.2 -2.7 -2.1 -0.9 3.6 -8.8
VOLDU (19) 1.3 -4.8 -1.7 18.9 16.5 11.4 -1.5 1.6 -0.4 14.6 38.8 -0.1 27.0 32.3 -1.6 9.0 -8.4 -0.9
CVILLIQ (20) 0.9 29.6 48.1 2.2 5.0 1.9 -4.5 -36.8 13.2 -5.6 3.7 -4.7 4.1 3.1 -3.1 -1.0 0.5 -0.1 5.3
SDTURN (21) -2.2 -4.3 -1.0 6.7 12.8 7.0 27.7 -15.8 -11.1 20.4 3.8 -0.6 32.1 27.6 3.1 -1.3 -0.6 0.3 8.3 -7.8
PS (22) 0.4 -0.5 0.8 0.1 0.5 -0.8 -4.6 1.5 2.0 0.0 0.7 -21.0 -3.6 -2.7 -0.5 0.5 0.2 -0.2 0.6 1.9 -4.1
BETA1 (23) -1.4 5.6 5.9 4.1 7.7 7.9 76.8 -24.5 -10.4 5.0 1.7 3.4 33.5 27.8 3.3 -0.6 -1.1 -0.3 -1.5 -3.2 26.9 -10.0
BETA2 (24) -0.1 26.9 32.4 13.8 10.2 19.6 16.5 -33.2 4.0 7.4 3.7 -3.6 20.9 15.6 -2.4 0.4 -1.5 0.6 2.6 16.2 5.3 -2.7 16.6
BETA3 (25) 0.8 -2.6 -5.5 -3.1 -4.4 -4.9 -50.4 12.8 8.7 -3.3 0.0 2.7 -17.5 -14.3 -1.7 0.8 -0.3 0.3 1.1 1.0 -13.8 -2.6 -39.9 -15.8
BETA4 (26) 0.1 -17.4 -20.3 -8.6 -7.6 -12.4 -14.5 24.7 -2.0 -5.5 -2.2 1.3 -14.8 -11.1 1.7 0.0 1.0 -0.4 -1.5 -10.3 -5.2 2.3 -16.6 -44.3 11.1
SADKAF (27) 0.4 3.6 6.5 3.7 3.7 2.8 26.2 -6.4 2.1 4.5 1.5 7.1 6.8 5.4 -0.3 0.5 -0.6 0.0 1.2 3.2 3.4 5.9 7.8 5.1 -8.4 -3.8
SADKAV (28) 0.4 0.7 0.5 0.4 0.9 -0.3 -3.1 -0.5 1.3 -0.4 1.1 -13.7 -1.3 -1.0 0.0 -0.1 -0.2 -0.1 0.6 2.0 -1.7 18.0 -7.8 0.9 -6.1 -0.4 -22.1

CVRG (29) -0.9 -26.4 -52.3 -8.1 -11.9 -11.6 -12.1 76.5 -12.6 -6.4 -2.9 14.4 -24.9 -17.3 -3.7 0.4 0.5 0.0 -1.0 -33.8 -5.7 -1.3 -14.9 -25.4 10.3 19.2 -3.6 -1.2
INST (30) 0.6 -23.7 -49.9 -14.0 -11.7 -11.4 2.9 53.5 -5.5 -3.3 -4.1 13.6 -21.0 -14.8 2.5 1.5 -0.7 0.0 -2.4 -30.1 1.7 0.0 -1.0 -22.2 -0.4 15.9 -5.6 0.2 43.6
Table 2
Contemporaneous returns for portfolios formed on LIQU
For month t, NYSE, Amex and Nasdaq stocks are sorted into ten decile portfolios based on their
liquidity shock (LIQU) using the NYSE breakpoints. LIQU is defined as the negative Amihud’s (2002)
illiquidity measure (ILLIQ), demeaned using the past 12-month ILLIQ as the mean. This table reports
the equal- and value-weighted monthly contemporaneous returns (month t) and the alpha with respect
to the Fama-French (1993) factors for each LIQU portfolio. Columns “Avg. LIQU” and “Avg. ILLIQ”
report the average LIQU and ILLIQ values for each decile portfolio. The last column shows the average
market share of each portfolio. The last row shows the differences in monthly returns between High
and Low LIQU decile portfolios and the alphas. Average returns and alphas are defined in monthly
percentage terms. Newey-West t-statistics are given in parentheses. The sample covers the period from
August 1963 to December 2010.
Equal-weighted Value-weighted
Decile Avg. RET Alpha Avg. RET Alpha Avg. LIQU Avg. ILLIQ Mkt. shr.
1 (Low) -0.39 -1.61 0.04 -1.10 -0.8970 2.6533 4.73%
(-1.61) (-12.18) (0.17) (-8.20)
2 -0.25 -1.40 0.30 -0.78 -0.0803 0.2963 10.55%
(-1.00) (-12.73) (1.25) (-6.87)
3 0.22 -0.92 0.69 -0.39 -0.0335 0.1479 16.59%
(0.88) (-8.93) (2.85) (-3.55)
4 0.61 -0.51 1.12 0.07 -0.0132 0.0881 16.68%
(2.42) (-5.17) (4.51) (0.64)
5 0.96 -0.13 1.60 0.60 -0.0006 0.0704 15.22%
(4.01) (-1.58) (6.89) (8.01)
6 1.36 0.29 2.12 1.14 0.0111 0.0716 12.56%
(5.73) (4.17) (8.86) (13.49)
7 1.74 0.67 2.64 1.66 0.0270 0.0927 9.28%
(7.27) (10.14) (10.38) (14.34)
8 2.08 0.99 3.15 2.14 0.0551 0.1415 6.91%
(8.92) (13.52) (12.22) (16.59)
9 2.61 1.48 3.80 2.76 0.1209 0.2463 4.66%
(10.43) (18.00) (13.81) (18.55)
10 (High) 4.51 3.29 5.27 4.11 1.3128 0.9851 2.84%
(15.05) (25.93) (15.94) (22.67)
High-Low 4.90 4.89 5.23 5.20
(28.88) (28.92) (22.15) (21.67)
55

Table 3
One-month ahead returns for portfolios formed on liquidity shocks
For month t, NYSE, Amex and Nasdaq stocks are sorted into ten decile portfolios based on one of the three liquidity shock measures (LIQU, SPRDU and
LIQCU) using the NYSE breakpoints. LIQU denotes the liquidity shock, defined as the negative Amihud’s (2002) illiquidity measure (ILLIQ), demeaned
using the past 12-month ILLIQ as the mean. SPRDU is the shock to the monthly volume-weighted effective relative spread (SPRD), calculated in the same
fashion as LIQU. LIQCU denotes the conditional measure of liquidity shock, defined as the negative of the difference between the realized ILLIQ and the
conditional mean of ILLIQ in the month estimated under the assumption that the conditional mean of ILLIQ follows an ARMA(1,1) process. This table
reports the equal- and value-weighted one-month ahead returns (month t + 1) and the alpha with respect to the Fama-French (1993) factors for each liquidity
shock decile portfolio. The last row shows the differences in monthly returns between High and Low liquidity shock decile portfolios and the corresponding
alphas. Average returns and alphas are defined in monthly percentage terms. Newey-West t-statistics are given in parentheses. The sample period for the
results based on LIQU and LIQCU is from August 1963 to December 2010. The results for SPRDU are based on the sample period from January 1993 to
December 2010.
LIQU SPRDU LIQCU
Equal-weighted Value-weighted Equal-weighted Value-weighted Equal-weighted Value-weighted
Decile Avg. RET Alpha Avg. RET Alpha Avg. RET Alpha Avg. RET Alpha Avg. RET Alpha Avg. RET Alpha
1 (Low) 0.51 -0.75 0.43 -0.73 0.50 -0.55 0.56 -0.54 0.77 -0.49 0.60 -0.55
56
(1.84) (-8.75) (1.68) (-7.45) (1.42) (-4.18) (1.43) (-2.86) (2.87) (-6.84) (2.43) (-7.19)
2 0.72 -0.45 0.65 -0.42 0.97 -0.17 0.72 -0.32 0.76 -0.41 0.63 -0.41
(2.75) (-5.14) (2.71) (-4.53) (2.71) (-1.30) (1.80) (-2.06) (3.09) (-5.59) (2.79) (-6.13)
3 0.94 -0.17 0.84 -0.17 1.02 -0.06 0.83 -0.10 1.00 -0.10 0.98 -0.01
(3.81) (-1.88) (3.68) (-1.94) (3.00) (-0.53) (2.55) (-0.72) (4.34) (-1.27) (4.67) (-0.09)
4 1.04 -0.06 1.01 -0.01 0.92 -0.17 0.83 -0.11 1.05 -0.01 0.98 0.03
(4.41) (-0.79) (4.56) (-0.12) (2.76) (-2.08) (2.65) (-1.09) (4.75) (-0.20) (4.64) (0.60)
5 1.08 -0.02 0.99 -0.01 0.94 -0.11 0.82 -0.11 1.08 0.02 0.95 -0.01
(4.47) (-0.28) (4.36) (-0.21) (3.09) (-1.30) (2.81) (-1.59) (4.78) (0.35) (4.42) (-0.12)
6 1.07 -0.02 1.04 0.04 1.04 -0.02 0.88 0.00 1.19 0.09 1.14 0.15

(4.53) (-0.39) (4.84) (0.82) (3.37) (-0.21) (3.04) (0.00) (5.16) (1.37) (5.28) (2.75)
7 1.19 0.10 1.21 0.23 0.98 -0.05 0.87 -0.03 1.23 0.11 1.08 0.10
(5.17) (1.74) (5.45) (3.63) (3.27) (-0.67) (2.94) (-0.37) (5.13) (1.73) (4.71) (1.60)
8 1.23 0.10 1.16 0.15 1.01 -0.02 1.12 0.23 1.30 0.12 1.22 0.17
(5.04) (1.71) (4.97) (1.96) (3.35) (-0.20) (3.66) (1.68) (5.13) (2.24) (5.01) (2.76)
9 1.34 0.18 1.29 0.24 1.19 0.14 1.18 0.23 1.41 0.22 1.30 0.23
(5.27) (2.89) (5.32) (3.49) (3.76) (1.77) (3.49) (1.74) (5.51) (3.94) (5.24) (3.49)
10 (High) 1.69 0.48 1.60 0.45 1.42 0.43 1.23 0.25 1.52 0.27 1.40 0.22
(6.02) (6.88) (6.01) (6.01) (4.25) (4.21) (3.39) (1.75) (5.25) (4.38) (4.97) (3.83)
High-Low 1.18 1.23 1.17 1.17 0.92 0.98 0.67 0.79 0.75 0.76 0.80 0.78
(10.18) (10.13) (8.01) (7.64) (5.08) (5.94) (2.26) (2.90) (7.76) (8.93) (5.73) (6.81)
Table 4
Bivariate portfolio sorts
This table reports the equal-weighted returns and return differences in month t + 1 between High and Low liquidity shock (LIQU) quintile
portfolios and the Fama-French (1993) alphas after controlling for a given stock characteristic. LIQU is computed as the negative Amihud’s
(2002) illiquidity measure, demeaned using the past 12-month illiquidity as the mean. BETA, LNME, and LNBM denote the market beta,
the natural logarithm of the market capitalization, and the natural logarithm of the book-to-market equity ratio, respectively. MOM is the
momentum return. REV is the short-term reversal. COSKEW and IVOL are the co-skewness and idiosyncratic volatility, respectively. MAX
denotes the maximum daily return in a month. DISP measures the analyst earnings forecast dispersion. SUE is the standardized unexpected
earnings. CVILLIQ is the coefficient of variation in the Amihud’s illiquidity measure. SDTURN denotes the standard deviation of the monthly
turnover over the past 12 months. PS is thePastor and Stambaugh’s (2003) liquidity beta. BETA1–BETA4 are Acharya and Pedersen’s (2005)
four liquidity betas. SADKAF and SADKAV are the loadings on the fixed and the variable components of Sadka’s (2006) liquidity factor.
GKM divides the sample into the high, median, and low dollar trading volume groups. VOLDU measures the abnormal dollar trading volume.
Newey-West t-statistics are reported in parentheses.
Quintile BETA SIZE BM MOM REV COSKEW IVOL MAX DISP SUE ILLIQ
1 (Low) 0.63 0.68 0.50 0.73 0.45 0.57 0.74 0.73 0.68 0.87 0.69
2 0.97 0.93 0.98 0.89 0.92 0.93 0.93 0.91 1.02 1.23 0.95
57
3 1.14 1.19 1.15 1.07 1.10 1.10 1.12 1.12 1.16 1.32 1.16
4 1.38 1.32 1.40 1.34 1.39 1.41 1.40 1.39 1.37 1.54 1.30
5 (High) 1.74 1.43 1.71 1.64 1.79 1.72 1.76 1.84 1.69 1.84 1.51
High - Low 1.12 0.75 1.21 0.91 1.35 1.16 1.02 1.11 1.01 0.96 0.82
(7.46) (5.89) (7.84) (7.38) (7.65) (7.46) (7.89) (7.50) (7.04) (6.61) (5.37)
Alpha 1.15 0.85 1.24 0.88 1.36 1.19 1.03 1.13 1.02 0.99 0.85
(7.09) (6.38) (7.72) (7.96) (7.77) (7.55) (7.06) (7.15) (7.59) (6.84) (5.43)
Quintile CVILLIQ SDTURN PS BETA1 BETA2 BETA3 BETA4 SADKAF SADKAV GKM VOLDU

1 (Low) 0.46 0.60 0.56 0.51 0.58 0.45 0.57 0.34 0.35 0.62 0.62
2 0.97 0.96 0.92 0.92 0.89 0.89 0.85 0.92 0.95 0.99 0.87
3 1.12 1.11 1.09 1.04 1.08 1.04 1.04 1.04 1.04 1.10 1.09
4 1.30 1.39 1.32 1.28 1.23 1.30 1.26 1.22 1.21 1.21 1.37
5 (High) 1.66 1.74 1.69 1.61 1.35 1.63 1.40 1.51 1.54 1.66 1.67
High - Low 1.20 1.14 1.13 1.11 0.76 1.18 0.82 1.18 1.19 1.03 1.05
(7.40) (7.93) (7.29) (7.63) (6.58) (7.89) (6.74) (7.63) (7.54) (7.60) (7.94)
Alpha 1.22 1.17 1.18 1.18 0.88 1.25 0.91 1.33 1.34 0.99 0.99
(7.39) (7.58) (7.45) (7.43) (7.87) (7.11) (7.35) (7.60) (7.22) (7.42) (7.20)
Table 5
Bivariate sorts controlling for volume shocks and idosyncratic volatility shocks
This table reports the average returns in month t + 1 for each portfolio obtained from conditional bivari-
ate sorts by volume shocks (VOLDU) and LIQU (Panel A), and idosyncratic volatility shocks (IVOLU)
and LIQU (Panel B). The last column in each panel reports the average returns for each LIQU port-
folio across the five control variable quintiles (VOLDU in Panel A, and IVOLU in Panel B). The last
two rows in each panel present the return differences between the highest and the lowest LIQU portfo-
lios within each control quintile and the corresponding alphas with respect to the Fama-French (1993)
factors. Newey-West t-statistics are reported in parentheses.
Panel A. Control for VOLDU

LIQU VOLDU (Low) VOLDU 2 VOLDU 3 VOLDU 4 VOLDU (High) Avg. RET
1 (Low) 0.45 0.35 0.61 0.72 0.97 0.62
2 0.42 0.81 0.91 1.03 1.16 0.87
3 0.88 0.94 1.05 1.19 1.39 1.09
4 1.03 1.21 1.36 1.52 1.74 1.37
5 (High) 1.27 1.63 1.66 1.78 1.99 1.67
High - Low 0.82 1.28 1.05 1.07 1.02 1.05
(8.10) (10.74) (7.81) (7.02) (5.64) (7.94)
Alpha 0.93 1.28 0.98 0.90 0.87 0.99
(9.72) (10.82) (7.76) (7.09) (6.01) (7.20)
Panel B. Control for IVOLU

LIQU IVOLU (Low) IVOLU 2 IVOLU 3 IVOLU 4 IVOLU (High) Avg. RET
1 (Low) 0.65 0.70 0.84 0.69 -0.02 0.57
2 1.04 0.94 0.98 0.99 0.49 0.89
3 1.14 1.15 1.11 1.14 0.82 1.07
4 1.64 1.36 1.30 1.38 1.20 1.38
5 (High) 1.96 1.96 1.79 1.76 1.43 1.78
High - Low 1.31 1.26 0.95 1.06 1.45 1.21
(7.46) (8.02) (5.09) (5.94) (6.24) (7.91)
Alpha 1.33 1.27 0.96 1.08 1.49 1.23
(7.52) (7.60) (5.08) (5.81) (6.97) (8.09)
58

Table 6
Stock-level cross-sectional regressions
Monthly excess stock returns are regressed on a set of lagged predictive variables using the Fama and
MacBeth (1973) methodology. This table reports the average slope coefficients and Newey-West t-
statistics in parentheses. LIQU denotes the liquidity shock, defined as the negative Amihud’s (2002)
illiquidity measure (ILLIQ), demeaned using the past 12-month ILLIQ as the mean. SPRDU is the
shock to the monthly volume-weighted effective relative spread (SPRD), calculated in the same fashion
as LIQU. LIQCU denotes the conditional measure of liquidity shock, defined as the negative of the
difference between the realized ILLIQ and the conditional mean of ILLIQ in the month estimated under
the assumption that the conditional mean of ILLIQ follows an ARMA(1,1) process. BETA, LNME,
and LNBM denote the market beta, the natural logarithm of the market capitalization, and the natural
logarithm of the book-to-market equity ratio, respectively. MOM is the momentum return. REV is the
short-term reversal. COSKEW and IVOL are the co-skewness and idiosyncratic volatility, respectively.
MAX denotes the maximum daily return in a month. DISP measures the analyst earnings forecast
dispersion. SUE is the standardized unexpected earnings. CVILLIQ is the coefficient of variation in
the Amihud’s illiquidity measure. SDTURN denotes the standard deviation of the monthly turnover
over the past 12 months. PS is Pastor and Stambaugh’s (2003) liquidity beta. BETA1–BETA4 are
Acharya and Pedersen’s (2005) four liquidity betas. SADKAF and SADKAV are the loadings on the
fixed and the variable components of Sadka’s (2006) liquidity factor. GKMH and GKML denote the
high- and low-volume dummy variables. VOLDU measures the abnormal dollar trading volume.
59

Variable LIQU SPRDU LIQCU
(1) (2) (1) (2) (1) (2)
LIQ-Shock 0.201 0.175 0.632 0.554 0.179 0.146
(5.00) (4.36) (7.41) (6.80) (5.12) (3.59)
BETA 0.156 0.171 0.264 0.278 0.175 0.188
(1.41) (1.56) (2.19) (2.32) (1.57) (1.69)
LNME -0.066 -0.096 -0.065 -0.081 -0.044 -0.085
(-2.03) (-2.94) (-1.58) (-1.99) (-1.35) (-2.59)
LNBM 0.140 0.125 0.101 0.091 0.148 0.126
(1.82) (1.65) (1.20) (1.09) (1.95) (1.68)
MOM 0.005 0.003 0.004 0.002 0.005 0.003
(3.33) (2.04) (2.04) (1.18) (3.20) (2.05)
REV -0.033 -0.048 -0.028 -0.041 -0.034 -0.048
(-6.13) (-8.84) (-5.20) (-7.77) (-6.18) (-8.64)
COSKEW 0.119 0.105 0.731 0.689 0.280 0.252
(0.15) (0.13) (0.87) (0.83) (0.36) (0.33)
IVOL -0.307 -0.383 -0.247 -0.334 -0.279 -0.356
(-6.47) (-7.89) (-4.24) (-5.49) (-5.62) (-7.17)
MAX -0.012 -0.002 -0.018 -0.011 -0.009 0.000
(-1.25) (-0.21) (-1.58) (-0.96) (-0.90) (-0.01)
DISP -0.070 -0.064 -0.09 -0.08 -0.079 -0.074
(-2.27) (-2.07) (-2.32) (-2.17) (-2.51) (-2.37)
SPRD 0.059 0.102
(0.88) (1.50)
ILLIQ 0.051 0.032 0.176 0.154 0.068 0.052
(1.95) (1.32) (4.55) (4.09) (2.63) (2.08)
CVILLIQ 0.098 0.034 0.102 0.032 0.112 0.045
(1.66) (0.58) (1.51) (0.47) (1.81) (0.74)
SDTURN -0.271 -0.226 -0.233 -0.176 -0.263 -0.215
(-2.94) (-2.51) (-2.43) (-1.86) (-2.83) (-2.36)
PS 0.001 0.001 0.001 0.001 0.002 0.002
(1.28) (1.18) (0.96) (0.89) (1.44) (1.34)
BETA1 0.180 0.181 0.210 0.215 0.136 0.138
(0.95) (0.97) (0.97) (1.01) (0.68) (0.70)
BETA2 -4.367 -3.606 2.963 2.869 -5.019 -3.544
(-1.14) (-0.96) (0.82) (0.81) (-1.15) (-0.83)
BETA3 1.638 1.541 3.977 3.874 2.020 1.871
(1.27) (1.21) (3.28) (3.22) (1.43) (1.34)
BETA4 -0.325 -0.334 -0.098 -0.091 -0.570 -0.571
(-0.98) (-1.02) (-0.28) (-0.27) (-1.38) (-1.40)
SADKAF -0.004 -0.004 0.000 0.000 -0.004 -0.003
(-1.12) (-1.16) (-0.03) (0.01) (-1.11) (-1.10)
SADKAV -0.016 -0.016 -0.011 -0.010 -0.016 -0.015
(-1.82) (-1.80) (-1.07) (-0.99) (-1.76) (-1.70)
SUE 0.303 0.283 0.276 0.254 0.303 0.283
(13.77) (12.99) (11.13) (10.42) (13.82) (13.07)
GKMH 0.547 0.523 0.537
(5.64) (4.76) (5.22)
GKML -0.071 -0.136 -0.079
(-1.10) (-1.85) (-1.17)
VOLDU 0.210 0.186 0.200
(9.77) (7.84) (9.35)
60

Table 7
Bivariate sorts controlling for attention and liquidity
Stocks are sorted into quintile portfolios based on an investor attention variable or the Amihud’s illiq-
uidity measure (ILLIQ) and then into quintile portfolios of liquidity shock (LIQU) within each control
quintile using NYSE breakpoints. The investor attention variables are the natural logarithm of mar-
ket capitalization (LNME), the number of analysts covering the stocks (CVRG), and the quarterly
aggregate institutional holdings (INST). This table reports the average returns for each of the 5 × 5
portfolios, the return differences between High and Low LIQU quintile portfolios within each control
variable quintile portfolio and the Fama-French (1993) alphas. The last column presents the 5 − 1 av-
erage return differences for each control variable within each LIQU quintile portfolio. Newey-West
t-statistics are given in parentheses.
Panel A. Control for LNME
LIQU LNME (Low) LNME 2 LNME 3 LNME 4 LNME (High) High - Low
1 (Low) 0.41 0.76 0.74 0.82 0.64 0.22
2 0.77 1.00 1.02 0.98 0.89 0.11
3 1.33 1.23 1.26 1.13 0.98 -0.35
4 1.72 1.45 1.33 1.19 0.89 -0.84
5 (High) 1.87 1.58 1.39 1.23 1.07 -0.80
High - Low 1.45 0.82 0.66 0.40 0.43 -1.02
(10.96) (5.27) (4.16) (2.66) (2.98) (-7.54)
Alpha 1.50 0.95 0.75 0.54 0.52 -0.98
(11.51) (5.80) (4.33) (3.32) (3.51) (-7.16)
Panel B. Control for CVRG

LIQU CVRG (Low) CVRG 2 CVRG 3 CVRG 4 CVRG (High) High - Low
1 (Low) 0.61 0.78 0.95 1.02 0.78 0.17
2 0.89 1.09 1.11 1.05 1.02 0.13
3 1.26 1.19 1.23 1.02 1.05 -0.21
4 1.62 1.32 1.18 1.18 1.03 -0.59
5 (High) 1.89 1.70 1.52 1.35 1.27 -0.62
High - Low 1.28 0.92 0.57 0.33 0.49 -0.79
(8.14) (5.01) (2.70) (1.71) (2.11) (-3.90)
Alpha 1.32 1.00 0.62 0.42 0.51 -0.81
(8.40) (5.89) (3.07) (2.11) (2.24) (-3.89)
61

Panel C. Control for INST
LIQU INST (Low) INST 2 INST 3 INST 4 INST (High) High - Low
1 (Low) 0.23 0.50 0.74 0.75 0.72 0.49
2 0.54 0.98 1.22 1.15 1.09 0.55
3 1.04 1.03 1.26 1.20 1.11 0.07
4 1.55 1.36 1.22 1.20 1.13 -0.42
5 (High) 1.70 1.84 1.57 1.55 1.33 -0.37
High - Low 1.47 1.34 0.82 0.79 0.61 -0.86
(9.18) (7.34) (4.32) (4.15) (3.16) (-4.71)
Alpha 1.56 1.46 1.01 0.98 0.82 -0.74
(10.80) (8.82) (5.58) (5.53) (4.59) (-4.33)
Panel D. Control for ILLIQ

LIQU ILLIQ (Low) ILLIQ 2 ILLIQ 3 ILLIQ 4 ILLIQ (High) High - Low
1 (Low) 0.73 0.82 0.79 0.67 0.45 -0.29
2 0.94 0.98 1.03 1.03 0.78 -0.15
3 0.99 1.18 1.24 1.19 1.18 0.19
4 0.98 1.17 1.31 1.39 1.65 0.68
5 (High) 1.26 1.30 1.45 1.75 1.81 0.55
High - Low 0.52 0.47 0.66 1.08 1.36 0.84
(3.44) (2.60) (3.24) (5.34) (10.56) (6.00)
Alpha 0.49 0.58 0.69 1.12 1.38 0.89
(3.03) (3.23) (3.24) (5.25) (10.99) (6.07)
62

Table 8
Monthly Fama-MacBeth regressions with interaction terms
One-month ahead excess returns are regressed on the Amihud’s illiquidity measure (ILLIQ), one investor atten-
tion variable, the liquidity shock (LIQ-Shock), and the interactions between ILLIQ and LIQ-Shock and between
the attention variable and LIQ-Shock using the Fama-MacBeth (1973) methodology. LIQ-Shock is measured
by LIQU in Panel A, SPRDU in Panel B and LIQCU in Panel C. The investor attention variables are the nat-
ural logarithm of market capitalization (LNME), the number of analysts covering the stocks (CVRG), and the
quarterly aggregate institutional holdings (INST). We simultaneously control for a large set of cross-sectional
predictors: the investor attention variable (controlled for one at a time), the market beta (BETA), LNME, the
natural logarithm of the book-to-market equity ratio (LNBM), the momentum return (MOM), the short-term re-
versal (REV), the co-skewness (COSKEW), the idiosyncratic volatility (IVOL), the maximum daily return in a
month (MAX), the analyst earnings forecast dispersion (DISP), the standardized unexpected earnings (SUE), the
high- and low-volume dummy variables (GKMH and GKML ), the dollar trading volume shock (VOLDU), the
standard deviation of the monthly turnover over the past 12 months (SDTURN), the coefficient of variation in
the Amihud’s illiquidity measure (CVILLIQ), Pastor and Stambaugh’s (2003) liquidity beta (PS), Acharya and
Pedersen’s (2005) four liquidity betas (BETA1–BETA4), and the loadings on the fixed and the variable com-
ponents of Sadka’s (2006) liquidity factor (SADKAF and SADKAV). Specifications (1) and (2) control for the
GKM dummy variables (GKMH and GKML ) and the abnormal dollar trading volume (VOLDU), respectively.
For brevity, we suppress the average slope coefficients of the control variables, which are available in Table A10
of the online appendix. Newey-West t-statistics are given in parentheses.
Panel A. Liquidity shock measured by LIQU

LNME CVRG INST
Variable (1) (2) (1) (2) (1) (2)
LIQU 0.908 0.979 0.603 0.572 0.403 0.320
(4.68) (4.80) (6.82) (6.54) (6.79) (5.76)
LIQU×ILLIQ 0.100 0.086 0.100 0.055 0.027 0.003
(1.93) (1.66) (1.07) (0.60) (0.54) (0.06)
LIQU×ATTENTION -0.111 -0.148 -0.180 -0.234 -0.234 -0.304
(-3.34) (-4.12) (-3.11) (-3.94) (-2.01) (-2.56)
Panel B. Liquidity shock measured by SPRDU

LNME CVRG INST
Variable (1) (2) (1) (2) (1) (2)
SPRDU 1.721 1.650 0.825 0.753 0.788 0.679
(7.37) (7.06) (5.71) (5.26) (6.56) (5.85)
SPRDU×ILLIQ 0.322 0.272 0.019 0.043 0.116 0.057
(3.36) (2.87) (0.09) (0.20) (1.14) (0.55)
SPRDU×ATTENTION -0.228 -0.237 -0.313 -0.335 -0.815 -0.836
(-5.71) (-5.82) (-3.76) (-3.99) (-4.17) (-4.26)
Panel C. Liquidity shock measured by LIQCU

LNME CVRG INST
Variable (1) (2) (1) (2) (1) (2)
LIQCU 0.329 0.353 0.230 0.216 0.241 0.197
(3.39) (3.62) (3.78) (3.51) (3.87) (3.38)
LIQCU×ILLIQ 0.088 0.081 0.111 0.082 0.092 0.073
(2.45) (2.28) (1.27) (0.93) (2.42) (2.04)
LIQCU×ATTENTION -0.032 -0.046 -0.050 -0.073 -0.237 -0.261
(-1.87) (-2.67) (-1.53) (-2.15) (-1.90) (-2.04)
63

Table 9
Predicting long-term stock returns
Excess cumulative returns in two to six months into the future are regressed on a set of predictive variables measured in
month t using the Fama and MacBeth (1973) methodology. This table reports the average slope coefficients of LIQU (in
Panel A), and LIQU and the interactions between ILLIQ and LIQU and between LIQU and an attention variable – LNME in
Panel B, CVRG in Panel C and INST in Panel D. Specifications (1) and (2) control for the GKM dummy variables (GKMH
and GKML ) and the abnormal dollar trading volume (VOLDU), respectively. We simultaneously control for the market beta
(BETA), LNME, the natural logarithm of the book-to-market equity ratio (LNBM), the momentum return (MOM), the short-
term reversal (REV), the co-skewness (COSKEW), the idiosyncratic volatility (IVOL), the maximum daily return in a month
(MAX), the analyst earnings forecast dispersion (DISP), the standardized unexpected earnings (SUE), the high- and low-
volume dummy variables (GKMH and GKML ), the abnormal dollar volume (VOLDU), the standard deviation of the monthly
turnover over the past 12 months (SDTURN), the coefficient of variation in the Amihud’s illiquidity measure (CVILLIQ),
Pastor and Stambaugh’s (2003) liquidity beta (PS), Acharya and Pedersen’s (2005) four liquidity betas (BETA1–BETA4),
and the loadings on the fixed and the variable components of Sadka’s (2006) liquidity factor (SADKAF and SADKAV). We
suppress the average coefficients of the control variables, which are available upon request.The t-statistics (in parentheses)
are based on Hodrick (1992) robust standard errors.
Panel A. Without interaction terms

Variable 2-Month 3-Month 4-Month 5-Month 6-Month
(1) (2) (1) (2) (1) (2) (1) (2) (1) (2)
LIQU 0.320 0.294 0.401 0.378 0.502 0.481 0.577 0.557 0.654 0.632
(5.34) (4.76) (4.56) (4.25) (3.81) (3.69) (3.44) (3.32) (3.24) (3.14)
Panel B. Interacting with ILLIQ and LNME

(1) (2) (1) (2) (1) (2) (1) (2) (1) (2)
LIQU 1.454 1.507 1.938 1.991 2.428 2.478 2.727 2.767 3.054 3.097
(3.96) (4.03) (4.39) (4.42) (4.14) (4.14) (3.65) (3.62) (3.66) (3.67)
LIQU×ILLIQ 0.133 0.125 0.194 0.189 0.214 0.218 0.221 0.223 0.222 0.232
(1.35) (1.31) (1.71) (1.70) (1.30) (1.38) (1.05) (1.07) (0.93) (1.01)
LIQU×LNME -0.198 -0.228 -0.284 -0.315 -0.375 -0.402 -0.420 -0.444 -0.471 -0.496
(-3.02) (-3.36) (-3.53) (-3.79) (-3.59) (-3.73) (-3.16) (-3.21) (-3.22) (-3.32)
Panel C. Interacting with ILLIQ and CVRG

(1) (2) (1) (2) (1) (2) (1) (2) (1) (2)
LIQU 0.999 0.956 1.097 1.052 1.235 1.186 1.222 1.169 1.315 1.264
(5.99) (5.70) (4.52) (4.30) (3.84) (3.68) (3.04) (2.90) (2.75) (2.62)
LIQU×ILLIQ 0.199 0.147 0.089 0.024 0.057 0.020 0.115 0.192 0.232 0.323
(1.23) (0.90) (0.34) (0.09) (0.17) (0.06) (0.27) (0.43) (0.41) (0.54)
LIQU×CVRG -0.393 -0.448 -0.468 -0.523 -0.567 -0.614 -0.543 -0.579 -0.566 -0.599
(-3.49) (-3.91) (-2.94) (-3.26) (-2.72) (-2.89) (-2.04) (-2.13) (-1.82) (-1.91)
Panel D. Interacting with ILLIQ and INST

(1) (2) (1) (2) (1) (2) (1) (2) (1) (2)
LIQU 0.613 0.541 0.690 0.617 0.770 0.709 0.820 0.764 0.862 0.810
(6.04) (5.22) (4.70) (4.18) (3.70) (3.38) (3.17) (2.94) (2.78) (2.57)
LIQU×ILLIQ 0.035 0.016 0.058 0.039 0.050 0.041 0.012 0.003 0.035 0.036
(0.51) (0.24) (0.59) (0.41) (0.32) (0.28) (0.06) (0.02) (0.15) (0.16)
LIQU×INST -0.552 -0.607 -0.673 -0.723 -0.816 -0.851 -0.835 -0.865 -0.809 -0.838
(-2.07) (-2.20) (-1.86) (-1.92) (-1.56) (-1.81) (-1.54) (-1.58) (-1.26) (-1.30)
64

Table 10
Two-month ahead return predictability
Panel A of this table reports the equal- and value-weighted two-month ahead returns (month t + 2)
and the alphas with respect to the Fama-French (1993) factors for each decile portfolio formed on the
liquidity shock measured by the negative Amihud’s illiquidity measure, demeaned using the past 12
months as the mean. The last row shows the monthly return differences between High and Low LIQU
decile portfolios and the alphas. Panel B reports average returns and return differences in month t + 2
between High and Low LIQU quintile portfolios and the alphas after controlling for the abnormal dollar
trading volume (VOLDU) and the idiosyncratic volatility shock (IVOLU). Newey-West t-statistics are
given in parentheses.
Panel A. Univariate portfolio sorts

Decile Avg. RET Alpha Avg. RET Alpha
1 (Low) 0.90 -0.40 0.88 -0.34
(3.19) (-5.05) (3.40) (-3.81)
2 0.99 -0.20 0.95 -0.13
(3.75) (-2.21) (4.01) (-1.51)
3 1.01 -0.11 0.96 -0.05
(4.16) (-1.34) (4.33) (-0.61)
4 1.05 -0.06 1.00 -0.04
(4.38) (-0.80) (4.53) (-0.57)
5 1.05 -0.05 0.94 -0.07
(4.45) (-0.77) (4.17) (-1.08)
6 1.00 -0.10 1.06 0.05
(4.36) (-1.57) (5.00) (0.82)
7 1.08 -0.01 1.10 0.13
(4.57) (-0.13) (5.08) (1.96)
8 1.06 -0.04 1.09 0.11
(4.35) (-0.73) (4.67) (1.47)
9 1.24 0.09 1.23 0.17
(4.83) (1.69) (5.05) (2.64)
10 (High) 1.51 0.31 1.46 0.31
(5.30) (4.38) (5.39) (4.33)
High-Low 0.60 0.70 0.58 0.65
(5.56) (6.59) (4.20) (4.67)
65

Panel B. Bivariate portfolio sorts
Quintile Controlling for VOLDU Controlling for IVOLU
1 (Low) 0.99 0.91
2 0.96 1.01
3 1.04 1.01
4 1.22 1.19
5 (High) 1.49 1.53
High - Low 0.50 0.62
(5.01) (5.25)
Alpha 0.50 0.69
(5.34) (6.11)
66

Table 11
Predicting one-month ahead returns based on the NYSE/Amex, NYSE and S&P 500 samples
Columns “NYSE/Amex”, “NYSE” and “S&P 500” report the equal- and value-weighted monthly returns in month t + 1 and the alphas with re-
spect to the Fama-French (1993) factors for decile portfolios formed based on the liquidity shock (LIQU) in month t. The last row presents the
differences in monthly returns between High and Low LIQU decile portfolios and the alphas. Newey-West t-statistics are given in parentheses.
NYSE/Amex NYSE S&P 500

Equal-weighted Value-weighted Equal-weighted Value-weighted Equal-weighted Value-weighted
Decile Avg. RET Alpha Avg. RET Alpha Avg. RET Alpha Avg. RET Alpha Avg. RET Alpha Avg. RET Alpha
1 (Low) 0.58 -0.73 0.46 -0.75 0.89 -0.60 0.75 -0.63 0.83 -0.42 0.73 -0.41
(2.06) (-7.60) (1.77) (-6.86) (3.76) (-5.22) (3.34) (-4.83) (3.12) (-3.57) (2.83) (-3.30)
2 0.75 -0.49 0.67 -0.47 1.02 -0.41 0.95 -0.34 0.98 -0.14 0.90 -0.12
(2.85) (-5.08) (2.75) (-4.50) (4.69) (-3.50) (4.77) (-2.68) (3.97) (-1.29) (3.85) (-1.15)
3 0.95 -0.21 0.86 -0.20 1.15 -0.20 1.04 -0.18 0.95 -0.10 0.85 -0.12
(3.82) (-2.11) (3.74) (-2.03) (5.82) (-1.83) (5.81) (-1.70) (4.10) (-1.16) (3.79) (-1.41)
67
4 1.09 -0.05 1.06 0.02 1.28 -0.07 1.23 -0.01 1.04 0.03 0.95 0.02
(4.63) (-0.52) (4.86) (0.25) (6.77) (-0.77) (6.95) (-0.08) (4.71) (0.41) (4.22) (0.20)
5 1.08 -0.04 0.99 -0.04 1.31 -0.03 1.20 -0.03 1.07 0.08 1.00 0.07
(4.52) (-0.51) (4.43) (-0.52) (6.91) (-0.39) (6.79) (-0.33) (5.10) (1.39) (4.87) (1.05)
6 1.10 -0.02 1.04 0.01 1.34 -0.02 1.25 0.00 1.06 0.07 1.08 0.17
(4.70) (-0.30) (4.91) (0.19) (7.06) (-0.34) (7.25) (-0.04) (5.06) (0.96) (5.51) (2.60)
7 1.25 0.13 1.23 0.21 1.50 0.09 1.47 0.19 1.07 0.05 0.99 0.07
(5.51) (1.89) (5.73) (3.31) (7.69) (1.33) (8.07) (2.58) (5.04) (0.68) (4.92) (0.92)
8 1.29 0.11 1.18 0.10 1.54 0.06 1.43 0.04 1.22 0.20 1.14 0.19
(5.39) (1.45) (5.30) (1.35) (7.54) (0.88) (7.70) (0.59) (5.56) (2.63) (5.39) (2.43)

9 1.41 0.20 1.37 0.24 1.68 0.14 1.62 0.16 1.23 0.14 1.17 0.18
(5.67) (2.23) (5.88) (3.04) (7.75) (1.82) (8.12) (2.15) (5.33) (2.00) (5.40) (2.33)
10 (High) 1.72 0.44 1.61 0.40 1.96 0.34 1.79 0.21 1.46 0.26 1.34 0.23
(6.22) (5.33) (6.22) (4.87) (8.14) (3.66) (7.82) (2.23) (5.87) (3.11) (5.53) (2.76)
High-Low 1.14 1.17 1.15 1.14 1.07 0.94 1.04 0.84 0.63 0.68 0.61 0.65
(10.43) (10.51) (8.48) (8.24) (9.60) (6.90) (7.25) (5.23) (4.32) (4.71) (3.76) (3.98)
Table 12
Subperiod analysis
Each month, stocks are sorted into ten decile portfolios based on liquidity shock (LIQU), defined as
the negative Amihud’s (2002) illiquidity measure, demeaned using the past 12-month illiquidity as
the mean. This table reports the average monthly returns in month t + 1 and the Fama-French (1993)
alphas for each LIQU portfolio. The last row shows the differences in monthly returns between High
and Low LIQU decile portfolios and the alphas. In Panel A, column “Non-crisis period” covers the
period from August 1963 to December 2010 and excludes the financial crisis period, July 2007 − June
2009; the “expansionary” and “recessionary” periods are based on the NBER business cycle periods.
Panel B reports the results for five decades in our sample: August 1963 − July 1973, August 1973 −
July 1983, August 1983 − July 1993, August 1993 − July 2003, and August 2003 − December 2010.
Newey-West t-statistics are given in parentheses.
Panel A. Returns on the liquidity shock portfolios in expansionary vs. recessionary periods
Non-crisis periods Expansionary periods Recessionary periods
Decile Avg. RET Alpha Avg. RET Alpha Avg. RET Alpha
1 (Low) 0.64 -0.74 0.77 -0.70 -0.87 -0.86
(2.41) (-7.71) (3.09) (-7.07) (-0.86) (-4.78)
2 0.81 -0.47 0.94 -0.46 -0.49 -0.26
(3.25) (-4.85) (4.14) (-4.60) (-0.49) (-1.21)
3 1.05 -0.18 1.13 -0.21 -0.09 0.15
(4.55) (-1.75) (5.55) (-2.11) (-0.09) (0.64)
4 1.14 -0.09 1.23 -0.10 0.01 0.26
(5.13) (-1.08) (6.43) (-1.18) (0.01) (1.39)
5 1.21 -0.02 1.29 -0.05 -0.03 0.25
(5.47) (-0.24) (6.52) (-0.63) (-0.03) (1.45)
6 1.18 -0.04 1.29 -0.06 -0.09 0.21
(5.42) (-0.58) (6.59) (-0.89) (-0.10) (1.34)
7 1.30 0.07 1.39 0.00 0.13 0.41
(6.00) (1.25) (6.85) (0.06) (0.16) (2.78)
8 1.35 0.06 1.46 0.02 0.01 0.25
(5.73) (1.07) (6.66) (0.32) (0.02) (1.26)
9 1.45 0.13 1.56 0.09 0.16 0.41
(5.79) (2.17) (6.65) (1.59) (0.18) (1.71)
10 (High) 1.85 0.47 1.93 0.41 0.43 0.50
(6.72) (6.61) (7.31) (5.78) (0.46) (1.96)
High-Low 1.21 1.22 1.16 1.11 1.30 1.36
(10.42) (8.96) (9.37) (7.89) (4.02) (4.32)
68

Panel B. Returns on the liquidity shock portfolios for five decades in 1963-2010
08/1963−07/1973 08/1973−07/1983 08/1983−07/1993 08/1993−07/2003 08/2003−12/2010
Decile Avg. RET Alpha Avg. RET Alpha Avg. RET Alpha Avg. RET Alpha Avg. RET Alpha
1 (Low) 0.23 -0.78 1.39 -0.54 0.38 -0.57 0.14 -1.04 0.39 -0.59
(0.34) (-6.19) (2.27) (-3.08) (0.73) (-7.01) (0.28) (-4.66) (0.53) (-3.65)
2 0.22 -0.66 1.32 -0.27 0.77 -0.32 0.45 -0.81 0.87 -0.08
(0.39) (-5.43) (2.35) (-1.53) (1.50) (-2.86) (0.81) (-3.35) (1.23) (-0.51)
3 0.36 -0.46 1.46 0.04 1.20 -0.04 0.87 -0.26 0.76 -0.14
(0.63) (-3.27) (2.76) (0.27) (2.55) (-0.26) (1.89) (-0.97) (1.09) (-1.01)
4 0.53 -0.30 1.27 -0.13 1.36 0.16 1.01 -0.08 1.01 0.12
(0.94) (-2.47) (2.39) (-1.26) (3.17) (1.11) (2.52) (-0.38) (1.51) (0.99)
5 0.88 0.06 1.36 -0.02 1.21 0.07 1.02 -0.04 0.86 -0.05
69
(1.68) (0.77) (2.42) (-0.23) (2.81) (0.46) (2.48) (-0.26) (1.15) (-0.34)
6 0.70 -0.14 1.49 0.08 1.18 0.10 0.97 -0.11 0.98 0.07
(1.35) (-1.95) (2.66) (0.66) (2.86) (1.11) (2.43) (-0.78) (1.37) (0.64)
7 1.08 0.20 1.75 0.33 1.19 0.11 1.00 -0.10 0.84 -0.01
(2.17) (2.22) (3.16) (2.17) (2.71) (1.32) (2.39) (-0.70) (1.30) (-0.08)
8 1.07 0.13 1.88 0.28 1.15 0.17 1.02 -0.11 0.96 0.06
(2.10) (1.31) (3.12) (1.80) (2.48) (1.63) (2.14) (-0.74) (1.46) (0.56)
9 1.16 0.21 2.22 0.46 1.01 0.08 1.23 0.06 0.98 0.09
(1.97) (1.64) (3.55) (2.67) (2.08) (0.92) (2.52) (0.56) (1.60) (0.74)
10 (High) 1.64 0.54 2.48 0.41 1.34 0.40 1.89 0.84 0.94 0.08

(2.23) (3.78) (3.77) (2.22) (2.56) (4.77) (3.80) (5.31) (1.47) (0.52)
High-Low 1.41 1.32 1.09 0.95 0.96 0.96 1.75 1.88 0.55 0.67
(6.30) (6.09) (4.58) (2.87) (8.21) (8.55) (4.96) (6.21) (2.06) (2.94)
Table 13
Controlling for the signed small-trade turnover
Panel A of this table reports one-month ahead average returns and return differences between High
and Low liquidity shock quintile portfolios and the Fama-French (1993) alphas after controlling for the
signed small-trade turnover (SSTT). Panel B reports the average slope coefficients of liquidity shock
and SSTT from the Fama-MacBeth cross-sectional regressions of one-month ahead excess stock returns
on liquidity shock and SSTT, including all the other control variables listed in Table 6. Specifications
(1) and (2) control for the GKM dummy variables (GKMH and GKML ) and the abnormal dollar trading
volume (VOLDU), respectively. SSTT is defined as the small-trade buy-initiated turnover minus the
small-trade sell-initiated turnover, measured over the past one through 24 months. Liquidity shock is
measured by LIQU in Panels A1 and B1, SPRDU in Panels A2 and B2 and LIQCU in Panels A3 and
B3. Newey-West t-statistics are reported in parentheses.
Panel A. Conditional bivariate sorts
Panel A1. Liquidity shock measured by LIQU
Quintile 1-month SSTT 3-month SSTT 6-month SSTT 12-month SSTT 24-month SSTT
1 (Low) 0.34 0.33 0.31 0.26 0.46
2 0.88 0.91 0.90 0.90 0.97
3 0.98 0.99 1.01 1.01 1.13
4 1.24 1.24 1.25 1.20 1.29
5 (High) 1.49 1.49 1.46 1.36 1.48
High - Low 1.15 1.15 1.14 1.10 1.02
(4.25) (4.08) (4.30) (4.23) (3.48)
Alpha 1.29 1.28 1.26 1.23 1.17
(5.67) (5.33) (5.62) (5.51) (4.83)
Panel A2. Liquidity shock measured by SPRDU

1 (Low) 0.43 0.46 0.44 0.41 0.48
2 0.74 0.73 0.74 0.72 0.83
3 0.96 0.95 0.95 0.98 1.10
4 1.12 1.10 1.09 1.09 1.14
5 (High) 1.37 1.35 1.32 1.18 1.32
High - Low 0.94 0.89 0.88 0.77 0.84
(4.29) (4.21) (4.34) (4.00) (4.17)
Alpha 0.93 0.95 0.94 0.85 0.96
(5.09) (4.72) (4.99) (4.58) (4.94)
Panel A3. Liquidity shock measured by LIQCU

1 (Low) 0.43 0.42 0.42 0.39 0.42
2 0.75 0.75 0.75 0.75 0.81
3 1.04 1.09 1.10 1.09 1.19
4 1.23 1.23 1.21 1.10 1.18
5 (High) 1.26 1.25 1.23 1.17 1.29
High - Low 0.83 0.83 0.81 0.78 0.87
(4.68) (4.10) (4.01) (3.95) (3.70)
Alpha 1.12 0.98 0.95 0.95 1.04
(5.31) (4.43) (4.21) (4.28) (4.06)
70

Panel B. Monthly Fama-MacBeth regressions
Panel B1. Liquidity shock measured by LIQU
1-month SSTT 3-month SSTT 6-month SSTT 12-month SSTT 24-month SSTT
Variable (1) (2) (1) (2) (1) (2) (1) (2) (1) (2)
LIQU 0.227 0.206 0.220 0.199 0.267 0.244 0.276 0.247 0.232 0.205
(3.76) (3.41) (3.92) (3.55) (4.01) (3.62) (3.44) (3.07) (3.69) (3.27)
SSTT -14.635 -17.713 -12.217 -13.110 -7.355 -7.355 -3.458 -3.254 -2.500 -2.334
(-1.76) (-2.07) (-3.47) (-3.63) (-3.20) (-3.19) (-2.39) (-2.24) (-2.08) (-1.95)
Panel B2. Liquidity shock measured by SPRDU

Variable (1) (2) (1) (2) (1) (2) (1) (2) (1) (2)
71
SPRDU 0.655 0.565 0.618 0.527 0.672 0.570 0.556 0.451 0.623 0.536
(5.98) (5.16) (5.33) (4.59) (5.48) (4.68) (4.45) (3.58) (4.93) (4.25)
SSTT -10.087 -12.231 -10.787 -11.692 -6.990 -7.029 -4.424 -4.267 -2.318 -2.187
(-0.91) (-1.11) (-2.46) (-2.60) (-2.88) (-2.87) (-2.71) (-2.62) (-2.00) (-1.89)
Panel B3. Liquidity shock measured by LIQCU

Variable (1) (2) (1) (2) (1) (2) (1) (2) (1) (2)
LIQCU 0.156 0.127 0.163 0.136 0.159 0.131 0.142 0.112 0.165 0.140
(4.32) (3.11) (4.42) (3.21) (4.53) (3.27) (3.99) (2.75) (4.28) (3.23)

SSTT -14.972 -17.581 -12.648 -13.418 -7.610 -7.539 -3.536 -3.318 -2.531 -2.361
(-1.75) (-2.02) (-3.48) (-3.63) (-3.26) (-3.24) (-2.43) (-2.27) (-2.13) (-1.99)
Online Appendix
To save space in the paper, we present some of our findings in the Online Appendix. Table A1 presents
the monthly contemporaneous returns (month t) and the alphas for the decile portfolios constructed
based on the shock to effective spread (SPRDU) in Panel A and the conditional measure of shock
to Amihud’s illiquidity measure (LIQCU) in Panel B. Table A2 reports 5 × 5 portfolio results from
the conditional bivariate sorts of liquidity shocks (measured by the changes in Amihud’s illiquidity)
and the control variables. Table A3 provides bivariate portfolio results from the conditional sorts of
liquidity shocks (measured by SPRDU in Panel A and LIQCU in Panel B) and the control variables.
Table A4 presents bivariate portfolio results from the conditional sorts by liquidity shocks (LIQU,
SPRDU and LIQCU) after controlling for VOLDU and IVOLU. Table A5 investigates the orthogonal
components of SPRDU for predicting future stock returns. Table A6 shows stock-level cross-sectional
regression results after controlling for IVOLU and all other return predictors. Table A7 presents results
from the Fama-MacBeth cross-sectional regressions of one-month ahead returns on the liquidity shock
measures and the control variables. Panels A and B of Table A8, respectively, present the results
of the univariate portfolio sorts and stock-level Fama-MacBeth cross-sectional regressions based on
the shock to equal-weighted quoted spread (QSPRDU). Table A9 reports the 5 × 5 portfolio results
from conditional bivariate sorts of liquidity shocks (measured by SPRDU in Panel A and LIQCU in
Panel B) with control for the Amihud’s illiquidity measure and the attention variables. Table A10
reports results from the Fama-MacBeth cross-sectional regressions with interaction terms (interactions
between liquidity shocks and level of liquidity, and between liquidity shocks and attention proxies).
Table A11 shows the results from the Fama-MacBeth cross-sectional regressions of two- to six-month
ahead cumulative returns against liquidity shocks (measured by SPRDU in Panel A and LIQCU in
Panel B) with and without interaction terms. Table A12 shows two-month ahead returns for bivariate
portfolios of liquidity shocks & VOLDU and IVOLU. Table A13 reports the portfolio results (Panel A)
and the stock-level Fama-MacBeth cross-sectional regressions (Panel B) from quote midpoint returns.
Table A14 presents stock-level cross-sectional regressions results after accounting for microstructure
biases.
This Version: August 23, 2013

Table A1
Liquidity shocks and contemporaneous stock returns
For month t, NYSE, Amex and Nasdaq stocks are sorted into ten decile portfolios based on SPRDU in
Panel A and LIQCU in Panel B using the NYSE breakpoints. SPRDU is defined as the negative volume-
weighted relative effective spread (SPRD), demeaned using the past 12-month SPRD as the mean.
LIQCU denotes the conditional measure of liquidity shock, defined as the negative of the difference
between the realized ILLIQ and the conditional mean of ILLIQ in the month estimated under the
assumption that the conditional mean of ILLIQ follows an ARMA(1,1) process. This table reports the
equal- and value-weighted monthly contemporaneous returns (month t) and the alpha with respect to
the Fama-French (1993) factors for each LIQU portfolio. In Panel A, columns “Avg. SPRDU” and
“Avg. SPRD” report average SPRDU and SPRD values for each SPRDU decile portfolio. In Panel B,
columns “Avg. LIQCU” and “Avg. ILLIQ” report average LIQCU and ILLIQ values for each LIQCU
decile portfolio. In each panel, the last column shows the average market share of each portfolio, and
the last row presents the differences in monthly returns between High and Low LIQU decile portfolios
and the corresponding alphas. Average returns and alphas are defined in monthly percentage terms.
Newey-West t-statistics are given in parentheses. The samples for Panels A and B cover the periods
from January 1993 to December 2010 and August 1963 to December 2010, respectively.
Panel A: Portfolio sorts based on SPRDU
Decile Avg. RET Alpha Avg. RET Alpha Avg. SPRDU Avg. SPRD Mkt. shr.
1 (Low) -0.12 -1.16 -0.32 -1.41 -0.5934 2.2936 6.03%
(-0.32) (-5.21) (-0.71) (-5.02)
2 0.09 -1.05 -0.05 -1.15 -0.0648 0.8118 8.85%
(0.26) (-5.92) (-0.14) (-5.48)
3 0.53 -0.55 0.59 -0.39 -0.0170 0.5996 13.10%
(1.60) (-3.45) (1.82) (-2.36)
4 0.80 -0.25 1.05 0.13 0.0097 0.5031 15.99%
(2.54) (-2.07) (3.53) (1.03)
5 1.10 0.06 1.44 0.54 0.0301 0.4720 15.42%
(3.59) (0.48) (5.19) (4.46)
6 1.37 0.37 2.04 1.14 0.0502 0.4840 12.93%
(4.76) (3.50) (7.40) (10.09)
7 1.77 0.76 2.45 1.54 0.0740 0.5300 9.88%
(6.12) (7.27) (8.82) (11.34)
8 2.05 1.05 2.92 2.02 0.1082 0.6121 7.39%
(7.26) (10.08) (8.83) (9.32)
9 2.51 1.49 3.74 2.81 0.1730 0.7818 5.24%
(7.90) (11.74) (8.92) (9.51)
10 (High) 4.42 3.45 4.95 3.94 1.0497 1.4349 5.17%
(10.83) (15.25) (9.16) (10.01)
High-Low 4.54 4.61 5.26 5.36
(13.06) (13.14) (8.87) (9.45)

Table A1 – continued
Panel B: Portfolio sorts based on LIQCU
Decile Avg. RET Alpha Avg. RET Alpha Avg. LIQCU Avg. ILLIQ Mkt. shr.
1 (Low) -0.26 -1.49 0.15 -0.99 -0.8663 2.3145 2.55%
(-1.09) (-14.67) (0.63) (-9.44)
2 -0.31 -1.47 0.11 -0.93 -0.0456 0.2681 11.67%
(-1.30) (-16.51) (0.50) (-11.16)
3 0.14 -0.99 0.66 -0.35 -0.0155 0.1239 22.17%
(0.60) (-11.54) (2.88) (-4.37)
4 0.65 -0.44 1.23 0.23 -0.0041 0.0710 20.84%
(2.72) (-5.57) (5.23) (3.29)
5 1.12 0.05 1.79 0.81 0.0029 0.0603 15.52%
(4.84) (0.74) (7.93) (10.97)
6 1.57 0.50 2.42 1.44 0.0108 0.0699 10.53%
(6.76) (6.97) (10.32) (16.97)
7 1.89 0.82 2.78 1.83 0.0235 0.1004 7.51%
(8.01) (10.54) (11.51) (16.28)
8 2.20 1.08 3.24 2.21 0.0484 0.1655 4.34%
(9.09) (12.74) (12.66) (16.57)
9 2.61 1.45 3.72 2.64 0.1103 0.2929 2.57%
(10.22) (15.77) (13.21) (17.58)
10 (High) 4.16 2.90 4.84 3.68 1.4877 1.0427 2.29%
(12.93) (23.24) (14.84) (23.24)
High-Low 4.42 4.39 4.69 4.67
(25.95) (29.21) (22.13) (24.90)
ii

Table A2
5 × 5 bivariate sorts with liquidity shocks measured by LIQU
This table reports the average returns in month t + 1 for each portfolio obtained from conditional bi-
variate sorts with liquidity shocks measured by LIQU. LIQU is computed as the negative difference
between the Amihud’s (2002) illiquidity measure and its past 12-month mean. The last column in each
panel reports the average returns for each LIQU portfolio across the five control variable groups. The
last two rows in each panel present the return differences between the highest and the lowest LIQU
portfolios within each control group and the corresponding alphas with respect to the Fama-French
(1993) factors. BETA, LNME and LNBM denote the market beta, the natural logarithm of the market
capitalization and the natural logarithm of the book-to-market equity ratio, respectively. MOM is the
momentum return. REV is the short-term reversal. COSKEW and IVOL are the co-skewness and id-
iosyncratic volatility, respectively. MAX denotes the maximum daily return in a month. DISP measures
the analyst earnings forecast dispersion. SUE is the standardized unexpected earnings. CVILLIQ is the
coefficient of variation in the Amihud’s illiquidity measure. SDTURN denotes the standard deviation
of the monthly turnover over the past 12 months. PS is Pastor and Stambaugh’s (2003) liquidity beta.
BETA1–BETA4 are Acharya and Pedersen’s (2005) four liquidity betas. SADKAF and SADKAV are
the loadings on the fixed and the variable components of Sadka’s (2006) liquidity factor. GKM di-
vides the sample into the high, median, and low dollar trading volume groups. VOLDU measures the
abnormal dollar trading volume. Newey-West t-statistics are reported in parentheses.
Panel A. Control for BETA
LIQU BETA (Low) BETA 2 BETA 3 BETA 4 BETA (High) Avg. RET
1 (Low) 0.51 0.81 0.76 0.70 0.36 0.63
2 0.85 0.94 1.11 0.97 0.97 0.97
3 1.02 1.23 1.13 1.18 1.15 1.14
4 1.11 1.38 1.44 1.48 1.50 1.38
5 (High) 1.46 1.63 1.84 1.90 1.87 1.74
High - Low 0.95 0.83 1.08 1.20 1.51 1.12
(6.60) (7.41) (6.48) (8.46) (6.95) (7.46)
Alpha 0.94 0.85 1.07 1.27 1.64 1.15
(6.55) (7.83) (6.31) (9.47) (7.75) (7.09)
Panel B. Control for LNME

LIQU LNME (Low) LNME 2 LNME 3 LNME 4 LNME (High) Avg. RET
1 (Low) 0.41 0.76 0.74 0.82 0.64 0.68
2 0.77 1.00 1.02 0.98 0.89 0.93
3 1.33 1.23 1.26 1.13 0.98 1.19
4 1.72 1.45 1.33 1.19 0.89 1.32
5 (High) 1.87 1.58 1.39 1.23 1.07 1.43
High - Low 1.45 0.82 0.66 0.40 0.43 0.75
(10.96) (5.27) (4.16) (2.66) (2.98) (5.89)
Alpha 1.50 0.95 0.75 0.54 0.52 0.85
(11.51) (5.80) (4.33) (3.32) (3.51) (6.38)
iii

Panel C. Control for BM
LIQU BM (Low) BM 2 BM 3 BM 4 BM (High) Avg. RET
1 (Low) 0.00 0.37 0.55 0.76 0.80 0.50
2 0.78 0.85 0.96 1.14 1.19 0.98
3 0.91 0.96 1.07 1.25 1.54 1.15
4 1.07 1.23 1.34 1.53 1.81 1.40
5 (High) 1.31 1.65 1.76 1.76 2.05 1.71
High - Low 1.32 1.27 1.22 1.00 1.25 1.21
(7.38) (7.72) (8.96) (7.41) (9.30) (7.84)
Alpha 1.35 1.30 1.28 1.02 1.25 1.24
(7.14) (7.94) (8.70) (7.34) (9.08) (7.72)
Panel D. Control for MOM

LIQU MOM (Low) MOM 2 MOM 3 MOM 4 MOM (High) Avg. RET
1 (Low) -0.13 0.67 0.78 1.06 1.25 0.73
2 0.18 0.79 0.95 1.11 1.43 0.89
3 0.61 0.98 0.98 1.18 1.61 1.07
4 0.82 1.18 1.28 1.48 1.96 1.34
5 (High) 0.98 1.47 1.75 1.84 2.16 1.64
High - Low 1.12 0.80 0.97 0.78 0.91 0.91
(9.24) (7.63) (8.43) (5.99) (5.44) (7.38)
Alpha 1.12 0.80 0.90 0.75 0.83 0.88
(9.12) (7.49) (7.65) (6.09) (5.57) (7.96)
Panel E. Control for REV

LIQU REV (Low) REV 2 REV 3 REV 4 REV (High) Avg. RET
1 (Low) 1.18 0.71 0.66 0.24 -0.56 0.45
2 1.25 1.19 0.92 0.79 0.43 0.92
3 1.41 1.24 1.13 0.98 0.76 1.10
4 1.69 1.53 1.37 1.20 1.16 1.39
5 (High) 2.25 1.92 1.74 1.61 1.45 1.79
High - Low 1.07 1.21 1.08 1.37 2.01 1.35
(6.95) (7.40) (7.86) (8.81) (9.51) (7.65)
Alpha 1.12 1.18 1.11 1.36 2.01 1.36
(7.75) (7.37) (7.79) (8.55) (9.46) (7.77)
Panel F. Control for COSKEW

LIQU COSKEW (Low) COSKEW 2 COSKEW 3 COSKEW 4 COSKEW (High) Avg. RET
1 (Low) 0.55 0.66 0.69 0.58 0.36 0.57
2 0.90 0.94 0.95 0.92 0.94 0.93
3 1.13 1.19 1.11 1.06 0.99 1.10
4 1.63 1.50 1.36 1.29 1.29 1.41
5 (High) 1.84 1.70 1.67 1.65 1.75 1.72
High - Low 1.29 1.04 0.98 1.07 1.39 1.16
(8.81) (8.05) (6.76) (9.00) (8.02) (7.46)
Alpha 1.33 1.08 0.98 1.12 1.44 1.19
(9.16) (8.14) (6.62) (8.99) (7.93) (7.55)
iv

Panel G. Control for IVOL
LIQU IVOL (Low) IVOL 2 IVOL 3 IVOL 4 IVOL (High) Avg. RET
1 (Low) 0.85 0.97 0.98 0.88 0.03 0.74
2 0.96 1.11 1.11 1.15 0.32 0.93
3 1.10 1.18 1.23 1.23 0.85 1.12
4 1.13 1.43 1.46 1.60 1.37 1.40
5 (High) 1.25 1.81 1.94 2.08 1.70 1.76
High - Low 0.40 0.84 0.96 1.20 1.67 1.02
(4.71) (7.13) (6.29) (7.73) (7.87) (7.89)
Alpha 0.39 0.83 0.97 1.22 1.75 1.03
(5.01) (7.81) (6.97) (8.66) (7.27) (7.06)
Panel H. Control for MAX

LIQU MAX (Low) MAX 2 MAX 3 MAX 4 MAX (High) Avg. RET
1 (Low) 1.01 1.09 1.06 0.74 -0.25 0.73
2 1.06 1.11 1.06 1.02 0.29 0.91
3 1.23 1.18 1.19 1.18 0.79 1.12
4 1.35 1.40 1.40 1.48 1.30 1.39
5 (High) 1.64 2.01 1.98 2.02 1.53 1.84
High - Low 0.63 0.92 0.91 1.28 1.78 1.11
(6.41) (7.38) (7.78) (8.47) (7.40) (7.50)
Alpha 0.64 0.94 0.90 1.31 1.85 1.13
(6.78) (8.27) (8.36) (9.11) (7.08) (7.15)
Panel I. Control for DISP

LIQU DISP (Low) DISP 2 DISP 3 DISP 4 DISP (High) Avg. RET
1 (Low) 0.58 1.06 0.91 0.68 0.16 0.68
2 0.95 1.18 1.20 1.01 0.78 1.02
3 1.27 1.23 1.20 1.15 0.96 1.16
4 1.77 1.35 1.25 1.37 1.10 1.37
5 (High) 1.77 1.64 1.75 1.70 1.59 1.69
High - Low 1.19 0.58 0.84 1.01 1.43 1.01
(7.58) (3.52) (5.60) (5.59) (7.19) (7.04)
Alpha 1.18 0.61 0.83 1.01 1.51 1.02
(7.71) (3.94) (5.75) (5.72) (7.90) (7.59)
Panel J. Control for SUE

LIQU SUE (Low) SUE 2 SUE 3 SUE 4 SUE (High) Avg. RET
1 (Low) 0.22 0.72 0.90 1.15 1.38 0.87
2 0.86 1.12 1.33 1.36 1.49 1.23
3 1.06 1.13 1.28 1.41 1.74 1.32
4 0.93 1.27 1.57 1.72 2.20 1.54
5 (High) 0.91 1.53 1.91 2.10 2.74 1.84
High - Low 0.69 0.81 1.02 0.95 1.35 0.96
(4.34) (5.32) (6.17) (4.91) (8.14) (6.61)
Alpha 0.80 0.85 1.04 0.96 1.32 0.99
(5.07) (5.48) (6.52) (4.98) (8.22) (6.84)

Panel K. Control for ILLIQ
LIQU ILLIQ (Low) ILLIQ 2 ILLIQ 3 ILLIQ 4 ILLIQ (High) Avg. RET
1 (Low) 0.73 0.82 0.79 0.67 0.45 0.69
2 0.94 0.98 1.03 1.03 0.78 0.95
3 0.99 1.18 1.24 1.19 1.18 1.16
4 0.98 1.17 1.31 1.39 1.65 1.30
5 (High) 1.26 1.30 1.45 1.75 1.81 1.51
High - Low 0.52 0.47 0.66 1.08 1.36 0.82
(3.44) (2.60) (3.24) (5.34) (8.56) (5.37)
Alpha 0.49 0.58 0.69 1.12 1.38 0.85
(3.03) (3.23) (3.24) (5.25) (8.99) (5.43)
Panel L. Control for CVILLIQ

LIQU CVILLIQ (Low) CVILLIQ 2 CVILLIQ 3 CVILLIQ 4 CVILLIQ (High) Avg. RET
1 (Low) 0.34 0.41 0.43 0.53 0.60 0.46
2 0.97 0.93 0.98 1.05 0.94 0.97
3 1.00 1.06 1.12 1.17 1.26 1.12
4 0.99 1.16 1.27 1.49 1.61 1.30
5 (High) 1.36 1.55 1.73 1.84 1.81 1.66
High - Low 1.02 1.14 1.31 1.32 1.21 1.20
(5.39) (6.86) (7.34) (8.27) (8.86) (7.40)
Alpha 1.04 1.16 1.32 1.32 1.25 1.22
(5.60) (6.76) (7.34) (7.99) (9.03) (7.39)
Panel M. Control for SDTURN

LIQU SDTURN (Low) SDTURN 2 SDTURN 3 SDTURN 4 SDTURN (High) Avg. RET
1 (Low) 0.74 0.72 0.71 0.65 0.20 0.60
2 0.93 0.97 1.06 1.08 0.76 0.96
3 1.09 1.09 1.21 1.22 0.96 1.11
4 1.32 1.39 1.45 1.49 1.30 1.39
5 (High) 1.61 1.83 1.82 1.89 1.56 1.74
High - Low 0.87 1.12 1.11 1.23 1.36 1.14
(9.59) (8.74) (8.96) (8.63) (7.52) (7.93)
Alpha 0.88 1.11 1.13 1.26 1.47 1.17
(9.54) (9.22) (9.47) (9.23) (7.75) (7.58)
Panel N. Control for PS

LIQU PS (Low) PS 2 PS 3 PS 4 PS (High) Avg. RET
1 (Low) 0.39 0.64 0.64 0.64 0.47 0.56
2 0.86 0.92 0.94 1.00 0.87 0.92
3 1.00 1.12 1.11 1.08 1.12 1.09
4 1.32 1.23 1.26 1.32 1.45 1.32
5 (High) 1.69 1.78 1.67 1.59 1.71 1.69
High - Low 1.30 1.13 1.03 0.94 1.24 1.13
(7.17) (8.81) (7.86) (6.42) (6.43) (7.29)
Alpha 1.39 1.17 1.07 0.99 1.30 1.18
(7.19) (8.63) (7.69) (6.91) (6.73) (7.45)
vi

Panel O. Control for BETA1
LIQU BETA1 (Low) BETA1 2 BETA1 3 BETA1 4 BETA1 (High) Avg. RET
1 (Low) 0.38 0.61 0.69 0.64 0.20 0.51
2 0.88 1.01 1.04 0.98 0.71 0.92
3 0.97 1.07 1.13 1.06 0.99 1.04
4 1.03 1.33 1.32 1.42 1.31 1.28
5 (High) 1.34 1.62 1.63 1.83 1.63 1.61
High - Low 0.97 1.01 0.94 1.19 1.43 1.11
(9.07) (8.96) (9.02) (8.59) (7.59) (7.63)
Alpha 0.98 1.09 0.96 1.26 1.59 1.18
(8.51) (9.89) (9.62) (9.16) (8.38) (7.43)
Panel P. Control for BETA2

1 (Low) 0.38 0.83 0.75 0.70 0.26 0.58
2 0.77 1.01 0.97 1.01 0.69 0.89
3 1.03 1.01 1.10 1.10 1.14 1.08
4 0.94 1.14 1.21 1.34 1.53 1.23
5 (High) 1.17 1.10 1.30 1.50 1.66 1.35
High - Low 0.79 0.27 0.56 0.81 1.40 0.76
(6.15) (1.90) (3.44) (5.64) (9.90) (6.58)
Alpha 0.91 0.39 0.70 0.93 1.50 0.88
(7.63) (2.90) (4.67) (6.38) (10.19) (7.87)
Panel Q. Control for BETA3

1 (Low) 0.31 0.50 0.63 0.61 0.22 0.45
2 0.68 0.99 1.00 0.97 0.82 0.89
3 0.91 1.05 1.11 1.10 1.00 1.04
4 1.27 1.44 1.34 1.27 1.18 1.30
5 (High) 1.57 1.66 1.77 1.56 1.61 1.63
High - Low 1.26 1.17 1.14 0.95 1.39 1.18
(6.01) (6.72) (7.61) (7.71) (6.98) (7.89)
Alpha 1.43 1.22 1.20 1.00 1.40 1.25
(6.55) (6.96) (7.25) (7.80) (6.41) (7.11)
Panel R. Control for BETA4

1 (Low) 0.35 0.62 0.62 0.81 0.47 0.57
2 0.67 0.91 0.90 0.92 0.86 0.85
3 1.15 1.06 1.08 0.95 0.96 1.04
4 1.54 1.34 1.19 1.09 1.16 1.26
5 (High) 1.69 1.50 1.23 1.21 1.35 1.40
High - Low 1.34 0.88 0.62 0.40 0.88 0.82
(8.90) (5.74) (3.92) (2.60) (6.70) (6.74)
Alpha 1.45 0.98 0.74 0.51 0.88 0.91
(9.06) (6.17) (4.84) (3.45) (6.72) (7.35)
vii

Panel S. Control for SADKAF
LIQU SADKAF (Low) SADKAF 2 SADKAF 3 SADKAF 4 SADKAF (High) Avg. RET
1 (Low) 0.11 0.44 0.62 0.51 0.02 0.34
2 0.73 0.99 1.13 0.94 0.83 0.92
3 0.83 1.01 1.08 1.16 1.11 1.04
4 1.00 1.14 1.13 1.39 1.46 1.22
5 (High) 1.47 1.54 1.44 1.56 1.53 1.51
High - Low 1.36 1.10 0.82 1.05 1.51 1.18
(6.49) (7.25) (5.22) (6.77) (6.83) (7.63)
Alpha 1.51 1.25 0.95 1.18 1.73 1.33
(7.19) (8.63) (6.60) (8.39) (8.94) (7.60)
Panel T. Control for SADKAV

LIQU SADKAV (Low) SADKAV 2 SADKAV 3 SADKAV 4 SADKAV (High) Avg. RET
1 (Low) 0.00 0.56 0.47 0.56 0.17 0.35
2 0.72 1.04 1.06 1.15 0.79 0.95
3 0.88 0.98 1.15 1.21 0.98 1.04
4 1.30 1.11 1.28 1.20 1.19 1.21
5 (High) 1.49 1.56 1.52 1.56 1.55 1.54
High - Low 1.49 0.99 1.05 1.00 1.38 1.19
(6.70) (5.90) (6.78) (5.92) (7.51) (7.54)
Alpha 1.67 1.16 1.18 1.14 1.51 1.34
(8.03) (7.19) (7.79) (6.95) (8.94) (7.22)
Panel U. Control for GKM

LIQU GKM (Low) GKM 2 GKM (High) Avg. RET – –
1 (Low) 0.71 0.45 0.70 0.62 – –
2 0.96 0.92 1.11 0.99 – –
3 1.01 1.05 1.24 1.10 – –
4 1.23 1.15 1.26 1.21 – –
5 (High) 1.41 1.57 2.00 1.66 – –
High - Low 0.71 1.12 1.27 1.03 – –
(4.66) (9.63) (6.00) (7.42) – –
Alpha 0.56 1.15 1.28 0.99 – –
(4.11) (9.74) (6.34) (7.60) – –
Panel V. Control for VOLDU

LIQU VOLDU (Low) VOLDU 2 VOLDU 3 VOLDU 4 VOLDU (High) Avg. RET
1 (Low) 0.45 0.35 0.61 0.72 0.97 0.62
2 0.42 0.81 0.91 1.03 1.16 0.87
3 0.88 0.94 1.05 1.19 1.39 1.09
4 1.03 1.21 1.36 1.52 1.74 1.37
5 (High) 1.27 1.63 1.66 1.78 1.99 1.67
High - Low 0.82 1.28 1.05 1.07 1.02 1.05
(8.10) (10.74) (7.81) (7.02) (5.64) (7.94)
Alpha 0.93 1.28 0.98 0.90 0.87 0.99
(9.72) (10.82) (7.76) (7.09) (6.01) (7.20)
viii

Table A3
Bivariate portfolio sorts - liquidity shock measured by SPRDU and LIQCU
This table reports the equal-weighted returns and return differences in month t + 1 between High and Low liquidity shock (SPRDU in Panel A or LIQCU in
Panel B) quintile portfolios and the three-factor alphas after controlling for a given stock characteristic. SPRDU is computed as the negative of the volume-
weighted relative effective spread (SPRD), demeaned using the past 12-month SPRD as the mean. LIQCU denotes the conditional measure of liquidity
shock, defined as the negative of the difference between the realized ILLIQ and the conditional mean of ILLIQ in the month estimated under the assumption
that the conditional mean of ILLIQ follows an ARMA(1,1) process. BETA, LNME, and LNBM denote the market beta, the natural logarithm of the market
capitalization, and the natural logarithm of the book-to-market equity ratio, respectively. MOM is the momentum return. REV is the short-term reversal.
COSKEW and IVOL are the co-skewness and idiosyncratic volatility, respectively. MAX denotes the maximum daily return in a month. DISP measures
the analyst earnings forecast dispersion. SUE is the standardized unexpected earnings. CVILLIQ is the coefficient of variation in the Amihud’s illiquidity
measure. SDTURN denotes the standard deviation of the monthly turnover over the past 12 months. PS is Pastor and Stambaugh’s (2003) liquidity beta.
BETA1–BETA4 are Acharya and Pedersen’s (2005) four liquidity betas. SADKAF and SADKAV are the loadings on the fixed and the variable components
of Sadka’s (2006) liquidity factor. GKM divides the sample into the high, median, and low dollar trading volume groups. VOLDU measures the abnormal
dollar trading volume. IVOLU denotes the idiosyncratic volatility shock. Newey-West t-statistics are reported in parentheses.
Panel A. Liquidity shock measured by SPRDU

Quintile BETA SIZE BM MOM REV COSKEW IVOL MAX DISP SUE SPRD ILLIQ
ix
1 (Low) 0.64 0.96 0.59 0.73 0.55 0.64 0.82 0.81 0.64 0.70 0.68 0.78
2 1.02 1.17 1.05 0.97 0.98 1.00 1.00 1.01 1.02 1.05 0.92 1.18
3 1.09 1.32 1.09 1.11 1.07 1.06 1.07 1.06 1.03 1.09 1.06 1.28
4 1.22 1.40 1.23 1.18 1.25 1.23 1.22 1.24 1.16 1.21 1.12 1.33
5 (High) 1.55 1.56 1.43 1.38 1.46 1.48 1.45 1.49 1.44 1.50 1.23 1.73
High - Low 0.91 0.54 0.83 0.65 0.91 0.84 0.63 0.68 0.80 0.80 0.55 0.76
(5.73) (3.86) (4.72) (5.15) (5.44) (4.59) (5.14) (5.15) (3.86) (4.23) (3.46) (4.41)
Alpha 0.99 0.56 0.89 0.63 0.96 0.92 0.67 0.70 0.86 0.86 0.63 0.81
(7.17) (4.05) (5.48) (5.39) (6.40) (5.47) (5.99) (5.61) (4.66) (4.94) (3.79) (4.24)
Quintile CVILLIQ SDTURN PS BETA1 BETA2 BETA3 BETA4 SADKAF SADKAV GKM VOLDU IVOLU

1 (Low) 0.59 0.69 0.67 0.62 0.75 0.58 0.70 0.59 0.59 0.66 0.65 0.70
2 0.98 1.05 1.01 1.02 0.96 0.99 0.97 1.00 1.01 1.08 0.95 0.95
3 1.04 1.06 1.05 1.12 1.06 1.07 1.04 1.06 1.05 1.01 1.08 1.00
4 1.09 1.25 1.26 1.21 1.15 1.22 1.16 1.20 1.22 1.07 1.22 1.22
5 (High) 1.40 1.49 1.52 1.53 1.31 1.57 1.32 1.44 1.45 1.21 1.36 1.49
High - Low 0.81 0.81 0.85 0.91 0.56 0.99 0.62 0.85 0.86 0.55 0.71 0.79
(3.12) (4.78) (4.94) (5.53) (2.74) (5.08) (2.98) (4.75) (4.64) (4.19) (5.30) (5.32)
Alpha 0.89 0.91 0.91 0.99 0.69 1.07 0.73 0.92 0.93 0.58 0.71 0.85
(3.83) (6.46) (5.61) (6.83) (3.58) (6.21) (3.69) (5.58) (5.35) (4.80) (5.44) (6.09)
Panel B. Liquidity shock measured by LIQCU
Quintile BETA SIZE BM MOM REV COSKEW IVOL MAX DISP SUE ILLIQ
1 (Low) 0.77 0.84 0.70 0.85 0.68 0.71 0.84 0.87 0.89 0.98 0.84
2 1.03 1.06 1.04 0.98 0.97 1.00 1.00 0.96 1.09 1.24 1.04
3 1.20 1.23 1.20 1.20 1.18 1.20 1.16 1.17 1.27 1.37 1.21
4 1.39 1.28 1.42 1.38 1.43 1.40 1.43 1.43 1.39 1.64 1.33
5 (High) 1.59 1.26 1.52 1.49 1.62 1.53 1.63 1.72 1.51 1.66 1.30
High - Low 0.82 0.42 0.82 0.64 0.94 0.82 0.79 0.85 0.63 0.68 0.46
(9.16) (3.97) (8.14) (7.45) (8.81) (7.92) (9.62) (10.07) (5.66) (5.86) (3.58)
Alpha 0.82 0.51 0.80 0.60 0.90 0.82 0.78 0.84 0.63 0.69 0.50
(10.91) (5.51) (9.38) (8.83) (10.59) (9.22) (12.04) (12.30) (7.43) (6.99) (4.67)
x
Quintile CVILLIQ SDTURN PS BETA1 BETA2 BETA3 BETA4 SADKAF SADKAV GKM VOLDU IVOLU
1 (Low) 0.71 0.78 0.72 0.69 0.76 0.67 0.74 0.61 0.60 0.82 0.82 0.76
2 1.02 0.98 0.98 0.98 0.98 0.97 0.97 1.04 1.08 0.95 0.95 0.96
3 1.21 1.21 1.15 1.15 1.13 1.09 1.10 1.15 1.13 1.20 1.17 1.19
4 1.36 1.42 1.37 1.30 1.22 1.36 1.23 1.24 1.26 1.26 1.42 1.38
5 (High) 1.46 1.60 1.49 1.42 1.24 1.42 1.29 1.27 1.31 1.58 1.50 1.61
High - Low 0.75 0.81 0.77 0.72 0.48 0.76 0.54 0.68 0.72 0.75 0.68 0.85
(5.85) (9.54) (7.71) (9.08) (5.35) (7.97) (5.89) (5.12) (5.28) (8.00) (6.80) (7.03)
Alpha 0.74 0.81 0.79 0.75 0.57 0.79 0.60 0.83 0.86 0.72 0.61 0.83

(7.12) (11.13) (8.99) (10.48) (6.79) (9.21) (6.92) (7.50) (7.32) (8.65) (8.43) (8.37)
Table A4
Bivariate portfolio sorts by liquidity shocks after controlling for VOLDU and IVOLU
This table reports the equal-weighted returns and return differences in month t + 1 between High and Low
liquidity shock (LIQU, SPRDU and LIQCU) quintile portfolios and the three-factor alphas after controlling
for the abnormal dollar trading volume (VOLDU) and the idiosyncratic volatility shock (IVOLU). Newey-West
t-statistics are reported in parentheses.
Controlling for VOLDU Controlling for IVOLU

LIQU SPRDU LIQCU LIQU SPRDU LIQCU
1 (Low) 0.62 0.65 0.82 0.57 0.70 0.76
2 0.87 0.95 0.95 0.89 0.95 0.96
3 1.09 1.08 1.17 1.07 1.00 1.19
4 1.37 1.22 1.42 1.38 1.22 1.38
5 (High) 1.67 1.36 1.50 1.78 1.49 1.61
High - Low 1.05 0.71 0.68 1.21 0.79 0.85
(7.94) (5.30) (6.80) (7.91) (5.32) (7.03)
Alpha 0.99 0.71 0.61 1.23 0.85 0.83
(7.20) (5.44) (8.43) (8.09) (6.09) (8.37)
xi

Table A5
Investigating the orthogonal components of SPRDU for predicting future stock returns
In Panel A, for month t, NYSE, Amex and Nasdaq stocks are sorted into ten decile portfolios based
on the orthogonal component of SPRDU obtained by estimating monthly cross-sectional regressions of
SPRDU separately against contemporaneous idiosyncratic volatility (IVOL) and idiosyncratic volatility
shock (IVOLU). SPRDU is defined as the negative volume-weighted relative effective spread (SPRD),
demeaned using the past 12-month SPRD as the mean. Panel A reports the average one-month ahead
returns (month t + 1) and the alpha with respect to the Fama-French (1993) factors for each liquidity
shock decile portfolio. The last row shows the differences in monthly returns between High and Low
liquidity shock decile portfolios and the corresponding alphas. Average returns and alphas are defined
in monthly percentage terms. In Panel B, monthly excess stock returns are regressed on a set of lagged
predictive variables using the Fama and MacBeth (1973) methodology. Panel B reports the average
slope coefficients. SPRDU-RESD denotes the orthogonal component of SPRDU. BETA, LNME, and
LNBM denote the market beta, the natural logarithm of the market capitalization, and the natural
dispersion. SUE is the standardized unexpected earnings. CVILLIQ is the coefficient of variation in the
Amihud’s illiquidity measure. SDTURN denotes the standard deviation of the monthly turnover over
the past 12 months. PS is Pastor and Stambaugh’s (2003) liquidity beta. BETA1–BETA4 are Acharya
and Pedersen’s (2005) four liquidity betas. SADKAF and SADKAV are the loadings on the fixed and
the variable components of Sadka’s (2006) liquidity factor. GKMH and GKML denote the high- and
low-volume dummy variables. VOLDU measures the abnormal dollar trading volume. IVOLU is the
idiosyncratic volatility shock. Newey-West t-statistics are given in parentheses.
Panel A. Univariate portfolio sorts
SPRDU orthogonal to IVOL SPRDU orthogonal to IVOLU
Decile Avg. RET Alpha Avg. RET Alpha
1 (Low) 0.44 -0.56 0.61 -0.44
(1.35) (-4.23) (1.72) (-3.71)
2 1.01 -0.05 1.01 -0.10
(3.13) (-0.40) (2.98) (-0.98)
3 0.96 -0.08 0.94 -0.12
(3.19) (-0.74) (2.95) (-1.37)
4 1.00 -0.06 1.02 -0.02
(3.15) (-0.76) (3.39) (-0.23)
5 1.03 -0.03 1.00 -0.03
(3.24) (-0.40) (3.34) (-0.30)
6 1.05 0.00 1.00 0.00
(3.48) (0.05) (3.42) (-0.02)
7 1.06 -0.02 0.99 -0.05
(3.34) (-0.19) (3.32) (-0.56)
8 1.07 0.00 1.04 -0.02
(3.27) (0.06) (3.33) (-0.21)
9 1.09 -0.02 1.13 0.02
(3.05) (-0.18) (3.27) (0.25)
10 (High) 1.46 0.38 1.37 0.33
(4.07) (3.49) (3.97) (3.18)
High-Low 1.02 0.94 0.76 0.77
(5.91) (5.17) (4.51) (4.57)
xii

Variable SPRDU orthogonal to IVOL SPRDU orthogonal to IVOLU
(1) (2) (1) (2)
SPRDU-RESD 0.631 0.550 0.621 0.472
(6.99) (6.38) (6.75) (4.93)
BETA 0.255 0.269 0.258 0.263
(2.05) (2.17) (2.07) (2.11)
LNME -0.068 -0.083 -0.080 -0.093
(-1.64) (-2.04) (-1.91) (-2.23)
LNBM 0.096 0.089 0.095 0.099
(1.16) (1.08) (1.18) (1.26)
MOM 0.004 0.002 0.004 0.002
(2.06) (1.18) (2.09) (1.20)
REV -0.027 -0.040 -0.027 -0.040
(-5.00) (-7.58) (-4.97) (-7.50)
COSKEW 0.700 0.657 0.707 0.668
(0.83) (0.79) (0.85) (0.81)
IVOL -0.247 -0.336 -0.248 -0.254
(-4.01) (-5.26) (-1.94) (-2.00)
MAX -0.015 -0.008 -0.017 -0.012
(-1.30) (-0.69) (-1.49) (-0.99)
DISP -0.086 -0.079 -0.085 -0.083
(-2.33) (-2.18) (-2.51) (-2.46)
SPRD 0.046 0.093 0.018 0.011
(0.67) (1.32) (0.20) (0.12)
ILLIQ 0.097 0.083 0.089 0.072
(3.29) (2.95) (3.02) (2.55)
CVILLIQ 0.085 0.017 0.079 0.024
(1.31) (0.26) (1.38) (0.41)
SDTURN -0.234 -0.177 -0.259 -0.253
(-2.42) (-1.86) (-2.56) (-2.52)
PS 0.001 0.001 0.001 0.001
(1.01) (0.96) (1.00) (0.96)
BETA1 0.231 0.237 0.203 0.174
(1.05) (1.09) (1.08) (0.95)
BETA2 0.198 0.055 -0.226 -0.446
(0.05) (0.01) (-0.06) (-0.12)
BETA3 3.947 3.843 3.904 3.771
(3.23) (3.17) (3.24) (3.17)
BETA4 -0.344 -0.340 -0.397 -0.401
(-0.81) (-0.82) (-0.94) (-0.97)
SADKAF 0.000 0.000 0.000 0.000
(-0.02) (0.01) (-0.08) (-0.02)
SADKAV -0.010 -0.010 -0.011 -0.011
(-1.01) (-0.96) (-1.09) (-1.06)
SUE 0.248 0.228 0.250 0.231
(10.26) (9.51) (10.44) (9.84)
GKMH 0.503 0.501
(4.62) (4.46)
GKML -0.140 -0.143
(-1.84) (-1.89)
VOLDU 0.168 0.170
(6.78) (6.53)
IVOLU -0.092 -0.178
(-0.84) (-1.58)
xiii

Table A6
Stock-level cross-sectional regressions with control for IVOLU
difference between the realized ILLIQ and the conditional mean of ILLIQ in the month estimated
under the assumption that the conditional mean of ILLIQ follows an ARMA(1,1) process. BETA,
LNME, and LNBM denote the market beta, the natural logarithm of the market capitalization, and
the natural logarithm of the book-to-market equity ratio, respectively. MOM is the momentum return.
REV is the short-term reversal. COSKEW and IVOL are the co-skewness and idiosyncratic volatility,
respectively. MAX denotes the maximum daily return in a month. DISP measures the analyst earnings
forecast dispersion. SUE is the standardized unexpected earnings. CVILLIQ is the coefficient of
variation in the Amihud’s illiquidity measure. SDTURN denotes the standard deviation of the monthly
turnover over the past 12 months. PS is Pastor and Stambaugh’s (2003) liquidity beta. BETA1–BETA4
are Acharya and Pedersen’s (2005) four liquidity betas. SADKAF and SADKAV are the loadings on
the fixed and the variable components of Sadka’s (2006) liquidity factor. GKMH and GKML denote
the high- and low-volume dummy variables. VOLDU measures the abnormal dollar trading volume.
IVOLU is the idiosyncratic volatility shock.
xiv

(1) (2) (1) (2) (1) (2)
LIQ-Shock 0.200 0.156 0.621 0.472 0.179 0.000
(4.80) (3.70) (6.75) (4.93) (5.00) (4.01)
BETA 0.179 0.185 0.258 0.263 0.179 0.189
(1.65) (1.71) (2.07) (2.11) (1.63) (1.72)
LNME -0.073 -0.089 -0.080 -0.093 -0.048 -0.078
(-2.17) (-2.69) (-1.91) (-2.23) (-1.39) (-2.31)
LNBM 0.138 0.135 0.095 0.099 0.149 0.137
(1.86) (1.87) (1.18) (1.26) (2.02) (1.87)
MOM 0.005 0.003 0.004 0.002 0.005 0.003
(3.27) (1.98) (2.09) (1.20) (3.14) (1.97)
REV -0.033 -0.048 -0.027 -0.040 -0.033 -0.048
(-6.20) (-9.04) (-4.97) (-7.50) (-6.31) (-8.93)
COSKEW 0.039 0.042 0.707 0.668 0.245 0.225
(0.05) (0.05) (0.85) (0.81) (0.31) (0.29)
IVOL -0.366 -0.371 -0.248 -0.254 -0.315 -0.331
(-3.57) (-3.67) (-1.94) (-2.00) (-3.10) (-3.32)
MAX -0.014 -0.006 -0.017 -0.012 -0.012 -0.005
(-1.50) (-0.65) (-1.49) (-0.99) (-1.22) (-0.48)
DISP -0.072 -0.069 -0.085 -0.083 -0.083 -0.081
(-2.54) (-2.46) (-2.51) (-2.46) (-2.83) (-2.78)
SPRD 0.018 0.011
(0.20) (0.12)
ILLIQ 0.046 0.035 0.089 0.072 0.067 0.056
(1.62) (1.32) (3.02) (2.55) (2.52) (2.18)
CVILLIQ 0.091 0.028 0.079 0.024 0.110 0.042
(1.54) (0.47) (1.38) (0.41) (1.78) (0.69)
SDTURN -0.233 -0.231 -0.259 -0.253 -0.247 -0.233
(-2.75) (-2.77) (-2.56) (-2.52) (-2.74) (-2.64)
PS 0.001 0.001 0.001 0.001 0.001 0.001
(1.13) (1.07) (1.00) (0.96) (1.29) (1.21)
BETA1 0.152 0.118 0.203 0.174 0.118 0.085
(0.94) (0.77) (1.08) (0.95) (0.69) (0.51)
BETA2 -3.715 -3.311 -0.226 -0.446 -3.432 -2.737
(-0.96) (-0.86) (-0.06) (-0.12) (-0.77) (-0.62)
BETA3 1.721 1.601 3.904 3.771 2.053 1.892
(1.36) (1.29) (3.24) (3.17) (1.50) (1.40)
BETA4 -0.366 -0.385 -0.397 -0.401 -0.549 -0.570
(-1.10) (-1.16) (-0.94) (-0.97) (-1.36) (-1.42)
SADKAF -0.003 -0.003 0.000 0.000 -0.003 -0.003
(-1.06) (-1.11) (-0.08) (-0.02) (-1.00) (-1.02)
SADKAV -0.016 -0.016 -0.011 -0.011 -0.015 -0.015
(-1.84) (-1.85) (-1.09) (-1.06) (-1.76) (-1.72)
SUE 0.000 0.000 0.000 0.000 0.000 0.000
(12.02) (12.34) (9.44) (9.84) (12.18) (11.48)
GKMH 0.554 0.501 0.551
(5.58) (4.46) (5.22)
GKML -0.083 -0.143 -0.091
(-1.29) (-1.89) (-1.35)
VOLDU 0.000 0.000 0.000
(8.33) (6.53) (7.98)
IVOLU -0.061 -0.037 0.000 -0.105 -0.024 -0.063
(-0.62) (-0.38) (0.00) (-0.89) (-0.25) (-0.65)
xv

Table A7
Stock-level cross-sectional regressions
difference between the realized ILLIQ and the conditional mean of ILLIQ in the month estimated under
the assumption that the conditional mean of ILLIQ follows an ARMA(1,1) process. BETA, LNME,
and LNBM denote the market beta, the natural logarithm of the market capitalization, and the natural
dispersion. SUE is the standardized unexpected earnings. CVILLIQ is the coefficient of variation in
the Amihud’s illiquidity measure. SDTURN denotes the standard deviation of the monthly turnover
over the past 12 months. PS is Pastor and Stambaugh’s (2003) liquidity beta. BETA1–BETA4 are
Acharya and Pedersen’s (2005) four liquidity betas. SADKAF and SADKAV are the loadings on the
fixed and the variable components of Sadka’s (2006) liquidity factor. GKMH and GKML denote the
high- and low-volume dummy variables. VOLDU measures the abnormal dollar trading volume.
xvi

Variable (1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
LIQU 0.267 0.195 0.205 0.201 0.206 0.176 0.201 0.175 0.331 0.295
(8.17) (6.22) (5.16) (4.99) (5.18) (4.52) (5.00) (4.36) (6.96) (6.05)
BETA 0.064 0.189 0.166 0.158 0.164 0.180 0.156 0.171 0.254 0.272
(0.60) (1.70) (1.63) (1.42) (1.61) (1.80) (1.41) (1.56) (2.35) (2.50)
LNME -0.052 -0.117 -0.058 -0.068 -0.057 -0.091 -0.066 -0.096 -0.115 -0.125
(-1.58) (-3.59) (-1.79) (-2.08) (-1.75) (-2.78) (-2.03) (-2.94) (-2.92) (-3.18)
LNBM 0.207 0.205 0.181 0.141 0.179 0.165 0.140 0.125 0.093 0.085
(2.72) (2.69) (2.32) (1.83) (2.30) (2.15) (1.82) (1.65) (1.42) (1.29)
MOM 0.007 0.006 0.005 0.006 0.004 0.005 0.003 0.004 0.003
(5.10) (3.61) (2.83) (4.07) (2.81) (3.33) (2.04) (2.85) (1.92)
REV -0.039 -0.036 -0.038 -0.031 -0.047 -0.033 -0.048 -0.026 -0.036
(-7.96) (-6.39) (-6.94) (-5.78) (-8.44) (-6.13) (-8.84) (-4.56) (-6.35)
COSKEW -0.054 0.270 0.131 0.264 0.240 0.119 0.105 0.732 0.705
(-0.10) (0.36) (0.16) (0.35) (0.32) (0.15) (0.13) (0.92) (0.89)
IVOL -0.427 -0.319 -0.285 -0.337 -0.423 -0.307 -0.383 -0.222 -0.274
(-8.59) (-6.35) (-6.00) (-6.69) (-8.18) (-6.47) (-7.89) (-4.15) (-4.94)
MAX -0.013 -0.013 -0.006 -0.018 -0.009 -0.012 -0.002 -0.013 0.000
(-1.43) (-1.37) (-0.59) (-1.92) (-0.95) (-1.25) (-0.21) (-1.05) (-0.02)
DISP -0.20 -0.07 -0.07 -0.07 -0.07 -0.07 -0.06 -0.08 -0.08
(-2.05) (-2.37) (-2.25) (-2.38) (-2.16) (-2.27) (-2.07) (-2.31) (-2.11)
SPRD -0.120 -0.091
(-1.47) (-1.21)
ILLIQ 0.030 0.044 0.054 0.042 0.025 0.051 0.032 0.005 0.007
(1.55) (1.97) (2.05) (1.88) (1.22) (1.95) (1.32) (0.14) (0.19)
CVILLIQ 0.076 0.097 0.078 0.009 0.098 0.034 0.178 0.111
(1.30) (1.64) (1.32) (0.15) (1.66) (0.58) (2.58) (1.66)
SDTURN -0.345 -0.267 -0.345 -0.305 -0.271 -0.226 -0.176 -0.164
(-3.69) (-2.93) (-3.70) (-3.28) (-2.94) (-2.51) (-2.14) (-1.98)
PS 0.001 0.001 0.001 0.001 0.001 0.001 0.001 0.001
(1.13) (1.32) (1.09) (0.99) (1.28) (1.18) (1.04) (1.06)
BETA1 0.164 0.163 0.177 0.183 0.180 0.181 0.246 0.246
(0.93) (0.87) (0.99) (1.05) (0.95) (0.97) (1.31) (1.33)
BETA2 -1.890 -4.292 -1.996 -1.344 -4.367 -3.606 0.368 0.561
(-0.80) (-1.13) (-0.84) (-0.58) (-1.14) (-0.96) (0.10) (0.16)
BETA3 1.855 1.604 1.880 1.814 1.638 1.541 3.760 3.716
(1.81) (1.24) (1.82) (1.79) (1.27) (1.21) (2.98) (2.94)
BETA4 -0.045 -0.321 -0.049 -0.052 -0.325 -0.334 -0.337 -0.319
(-0.19) (-0.98) (-0.21) (-0.22) (-0.98) (-1.02) (-1.06) (-1.01)
SADKAF -0.003 -0.004 -0.003 -0.003 -0.004 -0.004 0.000 0.000
(-1.03) (-1.17) (-1.00) (-1.04) (-1.12) (-1.16) (0.05) (-0.01)
SADKAV -0.010 -0.016 -0.010 -0.010 -0.016 -0.016 -0.010 -0.010
(-1.23) (-1.85) (-1.22) (-1.22) (-1.82) (-1.80) (-1.06) (-1.04)
SUE 0.296 0.303 0.283 0.279 0.262
(13.32) (13.77) (12.99) (12.74) (11.94)
GKMH 0.415 0.547 0.469
(4.07) (5.64) (4.57)
GKML -0.101 -0.071 -0.132
(-1.66) (-1.10) (-1.91)
VOLDU 0.230 0.210 0.210 0.120
(10.89) (9.77) (9.77) (8.93)
xvii

Variable (1) (2) (3) (4) (5) (6) (7) (8) (9)
SPRDU 0.421 0.328 0.532 0.576 0.615 0.592 0.512 0.632 0.554
(6.72) (5.38) (6.29) (6.68) (7.29) (6.84) (6.17) (7.41) (6.80)
BETA 0.170 0.210 0.207 0.236 0.266 0.235 0.249 0.264 0.278
(1.05) (1.47) (1.46) (1.96) (2.20) (1.97) (2.10) (2.19) (2.32)
LNME 0.015 -0.048 -0.057 -0.066 -0.069 -0.062 -0.080 -0.065 -0.081
(0.43) (-1.31) (-1.53) (-1.64) (-1.68) (-1.54) (-2.01) (-1.58) (-1.99)
LNBM 0.171 0.178 0.177 0.137 0.103 0.134 0.124 0.101 0.091
(1.59) (1.87) (1.81) (1.56) (1.22) (1.54) (1.44) (1.20) (1.09)
MOM 0.005 0.004 0.004 0.003 0.005 0.003 0.004 0.002
(2.80) (2.40) (2.29) (1.70) (2.60) (1.75) (2.04) (1.18)
REV -0.028 -0.028 -0.029 -0.033 -0.025 -0.038 -0.028 -0.041
(-5.16) (-5.11) (-5.22) (-5.97) (-4.61) (-7.04) (-5.20) (-7.77)
COSKEW 0.495 0.497 0.887 0.727 0.910 0.849 0.731 0.689
(0.69) (0.67) (1.01) (0.86) (1.04) (0.98) (0.87) (0.83)
IVOL -0.249 -0.307 -0.234 -0.224 -0.254 -0.350 -0.247 -0.334
(-3.67) (-4.51) (-3.95) (-3.80) (-4.33) (-5.67) (-4.24) (-5.49)
MAX -0.006 -0.014 -0.014 -0.012 -0.019 -0.013 -0.018 -0.011
(-0.47) (-1.12) (-1.14) (-1.01) (-1.62) (-1.10) (-1.58) (-0.96)
DISP -0.09 -0.09 -0.08 -0.08 -0.09 -0.08 -0.09 -0.08
(-2.40) (-2.44) (-2.35) (-2.31) (-2.35) (-2.18) (-2.32) (-2.17)
SPRD 0.014 0.092 0.040 0.049 0.049 0.092 0.059 0.102
(0.25) (1.45) (0.63) (0.74) (0.76) (1.41) (0.88) (1.50)
ILLIQ 0.134 0.169 0.180 0.166 0.141 0.176 0.154
(3.37) (4.47) (4.68) (4.36) (3.81) (4.55) (4.09)
CVILLIQ 0.097 0.103 0.097 0.021 0.102 0.032
(1.43) (1.53) (1.43) (0.30) (1.51) (0.47)
SDTURN -0.306 -0.234 -0.306 -0.244 -0.233 -0.176
(-3.25) (-2.43) (-3.27) (-2.66) (-2.43) (-1.86)
PS 0.001 0.001 0.001 0.001 0.001 0.001
(0.75) (0.98) (0.73) (0.66) (0.96) (0.89)
BETA1 0.215 0.192 0.225 0.238 0.210 0.215
(1.05) (0.90) (1.09) (1.18) (0.97) (1.01)
BETA2 2.823 3.054 2.700 2.680 2.963 2.869
(0.90) (0.85) (0.85) (0.86) (0.82) (0.81)
BETA3 3.240 3.989 3.226 3.116 3.977 3.874
(2.86) (3.30) (2.82) (2.76) (3.28) (3.22)
BETA4 0.125 -0.086 0.122 0.117 -0.098 -0.091
(0.44) (-0.25) (0.42) (0.41) (-0.28) (-0.27)
SADKAF 0.000 0.000 0.000 0.000 0.000 0.000
(-0.01) (0.01) (-0.03) (-0.05) (-0.03) (0.01)
SADKAV -0.009 -0.011 -0.009 -0.009 -0.011 -0.010
(-0.86) (-1.02) (-0.89) (-0.84) (-1.07) (-0.99)
SUE 0.268 0.276 0.254
(10.69) (11.13) (10.42)
GKMH 0.423 0.523
(3.75) (4.76)
GKML -0.145 -0.136
(-2.05) (-1.85)
VOLDU 0.204 0.186
(8.40) (7.84)
xviii

Variable (1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
LIQCU 0.198 0.180 0.177 0.168 0.177 0.157 0.169 0.148 0.135 0.116
(7.84) (6.86) (5.39) (5.07) (5.46) (3.63) (5.12) (3.59) (5.87) (4.12)
BETA 0.044 0.163 0.160 0.178 0.158 0.170 0.175 0.188 0.286 0.304
(0.41) (1.42) (1.53) (1.59) (1.51) (1.64) (1.57) (1.69) (2.65) (2.78)
LNME -0.032 -0.098 -0.039 -0.046 -0.038 -0.084 -0.044 -0.085 -0.088 -0.108
(-0.96) (-3.06) (-1.21) (-1.40) (-1.16) (-2.54) (-1.35) (-2.59) (-2.27) (-2.77)
LNBM 0.215 0.219 0.184 0.149 0.183 0.160 0.148 0.126 0.118 0.103
(2.90) (2.90) (2.36) (1.96) (2.35) (2.08) (1.95) (1.68) (1.85) (1.61)
MOM 0.007 0.006 0.004 0.006 0.004 0.005 0.003 0.005 0.003
(4.80) (3.45) (2.71) (3.91) (2.78) (3.20) (2.05) (3.08) (2.20)
REV -0.040 -0.036 -0.039 -0.031 -0.046 -0.034 -0.048 -0.027 -0.037
(-7.97) (-6.36) (-6.95) (-5.75) (-8.17) (-6.18) (-8.64) (-4.69) (-6.44)
COSKEW -0.092 0.373 0.287 0.375 0.334 0.280 0.252 0.821 0.773
(-0.17) (0.49) (0.37) (0.49) (0.44) (0.36) (0.33) (1.03) (0.97)
IVOL -0.407 -0.291 -0.257 -0.308 -0.397 -0.279 -0.356 -0.217 -0.269
(-8.23) (-5.88) (-5.18) (-6.22) (-7.86) (-5.62) (-7.17) (-4.08) (-4.87)
MAX -0.011 -0.009 -0.003 -0.014 -0.006 -0.009 0.000 -0.015 -0.004
(-1.15) (-0.90) (-0.27) (-1.41) (-0.60) (-0.90) (-0.01) (-1.29) (-0.30)
DISP -0.20 -0.08 -0.08 -0.08 -0.08 -0.08 -0.07 -0.08 -0.08
(-2.06) (-2.63) (-2.51) (-2.64) (-2.47) (-2.51) (-2.37) (-2.34) (-2.15)
SPRD -0.082 -0.056
(-1.35) (-1.29)
ILLIQ 0.032 0.063 0.070 0.062 0.048 0.068 0.052 0.104 0.107
(1.51) (2.67) (2.73) (2.58) (2.06) (2.63) (2.08) (2.65) (2.77)
CVILLIQ 0.103 0.113 0.103 0.030 0.112 0.045 0.191 0.122
(1.70) (1.82) (1.69) (0.50) (1.81) (0.74) (2.75) (1.79)
SDTURN -0.316 -0.258 -0.320 -0.272 -0.263 -0.215 -0.183 -0.172
(-3.54) (-2.80) (-3.56) (-3.07) (-2.83) (-2.36) (-2.25) (-2.10)
PS 0.001 0.002 0.001 0.001 0.002 0.002 0.001 0.001
(1.23) (1.47) (1.20) (1.10) (1.44) (1.34) (1.03) (1.03)
BETA1 0.125 0.117 0.138 0.149 0.136 0.138 0.173 0.174
(0.67) (0.59) (0.73) (0.80) (0.68) (0.70) (0.91) (0.93)
BETA2 -4.567 -4.868 -4.728 -3.069 -5.019 -3.544 5.547 5.733
(-1.23) (-1.13) (-1.25) (-0.86) (-1.15) (-0.83) (1.66) (1.73)
BETA3 1.714 1.978 1.753 1.639 2.020 1.871 4.015 3.959
(1.39) (1.40) (1.41) (1.34) (1.43) (1.34) (3.00) (2.95)
BETA4 -0.364 -0.555 -0.376 -0.383 -0.570 -0.571 -0.008 -0.020
(-0.98) (-1.36) (-1.00) (-1.03) (-1.38) (-1.40) (-0.02) (-0.06)
SADKAF -0.003 -0.004 -0.003 -0.003 -0.004 -0.003 0.000 0.000
(-1.16) (-1.15) (-1.12) (-1.13) (-1.11) (-1.10) (-0.08) (-0.10)
SADKAV -0.010 -0.016 -0.009 -0.009 -0.016 -0.015 -0.011 -0.010
(-1.14) (-1.77) (-1.13) (-1.09) (-1.76) (-1.70) (-1.17) (-1.09)
SUE 0.296 0.303 0.283 0.281 0.264
(13.39) (13.82) (13.07) (12.86) (12.01)
GKMH 0.406 0.537 0.489
(3.88) (5.22) (4.73)
GKML -0.082 -0.079 -0.136
(-1.24) (-1.17) (-1.98)
VOLDU 0.218 0.200 0.200 0.120
(10.08) (9.35) (9.35) (8.75)
xix

Table A8
Results based on equal-weighted quoted spread shock
QSPRDU is the negative equal-weighted quoted spread (QSPRD), demeaned using the past 12-month QSPRD as the mean. Panel A presents
the equal- and value-weighted one-month ahead returns for decile portfolios formed on QSPRDU, the return differentials between High and
Low QSPRDU deciles and the corresponding Fama-French (1993) alphas. Panel B reports the average slope coefficients of QSPRDU from the
monthly Fama-MacBeth regressions of one-month ahead returns on QSPRDU and all the other control variables listed in Table 6. Specifications
(1) and (2) control for the GKM dummy variables (GKMH and GKML ) and the abnormal dollar trading volume (VOLDU), respectively. For
brevity, we suppress the average coefficients of the control variables, which are available upon request. Newey-West t-statistics are reported in
parentheses.
Panel A. One-month ahead returns for portfolios formed on QSPRDU
Decile Equal-weighted Value-weighted
1 (Low) 0.48 0.56
2 0.95 0.84
3 0.95 0.89
xx
4 0.87 0.87
5 0.94 0.86
6 1.04 0.99
7 1.03 1.00
8 0.96 1.01
9 1.18 1.27
10 (High) 1.50 1.33
High-Low 1.02 0.77
(5.47) (2.88)
Alpha 1.09 0.85

(6.33) (3.30)

(1) (2)
0.557 0.481
(8.26) (7.24)
Table A9
Bivariate sorts with control for attention and liquidity
Stocks are sorted into quintile portfolios based on an investor attention variable or the Amihud’s illiq-
uidity measure (ILLIQ) and then into quintile portfolios of liquidity shock (SPRDU in Panel A and
LIQCU in Panel B) within each control quintile using NYSE breakpoints. The investor attention vari-
ables are the natural logarithm of market capitalization (LNME), the number of analysts covering the
stocks (CVRG), and the quarterly aggregate institutional holdings (INST). This table reports the aver-
age returns for each of the 5 × 5 portfolios, the return differences between High and Low LIQU quintile
portfolios within each control variable quintile portfolio and the Fama-French (1993) alphas. The last
column presents the 5−1 average return differences for each control variable within each LIQU quintile
portfolio. Newey-West t-statistics are given in parentheses.
Panel A1. Control for LNME
SPRDU LNME (Low) LNME 2 LNME 3 LNME 4 LNME (High) High-Low
1 (Low) 1.04 0.96 0.93 0.92 0.93 -0.11
2 1.16 1.30 1.09 1.11 1.04 -0.12
3 1.39 1.38 1.13 1.37 1.10 -0.29
4 1.74 1.33 1.21 1.30 1.09 -0.65
5 (High) 1.86 1.67 1.41 1.29 1.24 -0.62
High - Low 0.82 0.71 0.48 0.37 0.31 -0.51
(5.20) (3.64) (3.02) (2.25) (1.84) (-2.99)
Alpha 0.89 0.75 0.42 0.40 0.33 -0.56
(5.60) (4.56) (3.24) (2.45) (2.01) (-3.03)
Panel A2. Control for CVRG

SPRDU CVRG (Low) CVRG 2 CVRG 3 CVRG 4 CVRG (High) High-Low
1 (Low) 0.74 0.88 0.96 0.91 0.96 0.22
2 1.19 1.23 1.40 1.14 1.08 -0.12
3 1.28 1.41 1.37 1.16 1.17 -0.11
4 1.55 1.51 1.52 1.21 1.28 -0.28
5 (High) 1.77 1.80 1.62 1.49 1.42 -0.35
High - Low 1.03 0.92 0.65 0.58 0.46 -0.58
(4.80) (4.01) (2.72) (2.53) (1.98) (-3.57)
Alpha 1.05 0.97 0.67 0.59 0.49 -0.57
(5.23) (4.32) (2.75) (2.54) (2.17) (-3.49)
xxi

Panel A3. Control for INST
SPRDU INST (Low) INST 2 INST 3 INST 4 INST (High) High-Low
1 (Low) 0.29 0.67 0.91 0.83 0.99 0.70
2 0.80 1.10 1.14 0.95 1.08 0.28
3 0.99 1.00 1.13 0.93 0.99 0.00
4 1.36 1.14 1.17 1.07 1.03 -0.33
5 (High) 1.46 1.52 1.49 1.37 1.33 -0.13
High - Low 1.17 0.85 0.58 0.54 0.35 -0.83
(5.77) (3.39) (2.24) (2.08) (1.94) (-4.12)
Alpha 1.16 0.96 0.75 0.53 0.45 -0.64
(5.99) (4.55) (3.41) (2.67) (2.02) (-3.30)
Panel A4. Control for ILLIQ

SPRDU ILLIQ (Low) ILLIQ 2 ILLIQ 3 ILLIQ 4 ILLIQ (High) High-Low
1 (Low) 0.92 0.97 1.13 1.02 0.82 -0.15
2 1.09 1.12 1.19 1.22 1.28 0.16
3 1.28 1.11 1.38 1.30 1.34 0.22
4 1.25 1.11 1.30 1.38 1.60 0.50
5 (High) 1.41 1.58 1.87 1.90 1.88 0.30
High - Low 0.49 0.61 0.74 0.88 1.06 0.45
(2.22) (2.74) (3.36) (5.85) (6.71) (3.34)
Alpha 0.52 0.62 0.80 1.04 1.05 0.43
(2.06) (2.44) (3.61) (5.65) (6.64) (2.78)
xxii

Panel B1. Control for LNME
LIQCU LNME (Low) LNME 2 LNME 3 LNME 4 LNME (High) High-Low
1 (Low) 0.79 0.91 0.89 0.86 0.74 -0.05
2 1.00 1.14 1.11 1.13 0.92 -0.08
3 1.49 1.32 1.31 1.13 0.93 -0.56
4 1.59 1.41 1.29 1.19 0.93 -0.65
5 (High) 1.59 1.35 1.25 1.08 1.02 -0.57
High - Low 0.80 0.44 0.36 0.22 0.27 -0.52
(6.73) (3.44) (2.72) (1.44) (2.51) (-4.47)
Alpha 0.82 0.53 0.48 0.36 0.36 -0.46
(7.80) (4.56) (3.64) (2.69) (3.33) (-3.84)
Panel B2. Control for CVRG

LIQCU CVRG (Low) CVRG 2 CVRG 3 CVRG 4 CVRG (High) High-Low
1 (Low) 0.86 1.00 1.04 1.07 0.90 0.04
2 1.05 1.15 1.23 1.09 1.05 0.00
3 1.40 1.38 1.27 1.13 1.03 -0.37
4 1.54 1.34 1.19 1.22 1.16 -0.39
5 (High) 1.60 1.49 1.39 1.36 1.13 -0.47
High - Low 0.74 0.49 0.36 0.29 0.23 -0.51
(6.36) (3.47) (2.29) (1.97) (1.37) (-3.28)
Alpha 0.78 0.54 0.46 0.39 0.34 -0.44
(7.15) (4.45) (3.29) (3.07) (2.24) (-2.76)
Panel B3. Control for INST

LIQCU INST (Low) INST 2 INST 3 INST 4 INST (High) High-Low
1 (Low) 0.61 0.77 0.91 0.94 0.83 0.23
2 0.79 1.03 1.23 1.23 1.13 0.34
3 1.33 1.18 1.28 1.18 1.15 -0.18
4 1.42 1.44 1.34 1.44 1.16 -0.26
5 (High) 1.41 1.54 1.41 1.21 1.16 -0.24
High - Low 0.80 0.78 0.49 0.27 0.33 -0.47
(5.43) (5.11) (3.03) (1.53) (2.10) (-3.06)
Alpha 0.91 0.91 0.65 0.43 0.52 -0.38
(8.34) (6.67) (4.22) (2.80) (3.87) (-2.60)
Panel B4. Control for ILLIQ

LIQCU ILLIQ (Low) ILLIQ 2 ILLIQ 3 ILLIQ 4 ILLIQ (High) High-Low
1 (Low) 0.81 0.92 0.91 0.83 0.74 -0.07
2 0.97 1.06 1.11 1.08 0.98 0.01
3 0.99 1.15 1.26 1.29 1.34 0.34
4 1.01 1.25 1.39 1.49 1.52 0.51
5 (High) 1.14 1.21 1.18 1.47 1.50 0.36
High - Low 0.33 0.29 0.27 0.64 0.76 0.43
(2.85) (1.75) (1.60) (3.59) (6.53) (3.64)
Alpha 0.32 0.41 0.33 0.67 0.76 0.43
(2.87) (2.94) (2.17) (4.17) (7.34) (3.48)
xxiii

Table A10
Stock-level cross-sectional regressions with interaction terms
One-month ahead excess returns are regressed on the Amihud’s illiquidity measure (ILLIQ), one
investor attention variable, the liquidity shock (LIQ-Shock), and the interactions between ILLIQ
and LIQ-Shock and between the attention variable and LIQ-Shock using the Fama-MacBeth (1973)
methodology. LIQ-Shock is measured by LIQU in Panel A, SPRDU in Panel B and LIQCU in Panel C.
The investor attention variables are the natural logarithm of market capitalization (LNME), the number
of analysts covering the stocks (CVRG), and the quarterly aggregate institutional holdings (INST). We
control for a large set of cross-sectional predictors: the investor attention variable (controlled for one
at a time), the market beta (BETA), LNME, the natural logarithm of the book-to-market equity ratio
(LNBM), the momentum return (MOM), the short-term reversal (REV), the co-skewness (COSKEW),
the idiosyncratic volatility (IVOL), the maximum daily return in a month (MAX), the analyst earnings
forecast dispersion (DISP), the standardized unexpected earnings (SUE), the high- and low-volume
dummy variables (GKMH and GKML ), the dollar trading volume shock (VOLDU), the standard devi-
ation of the monthly turnover over the past 12 months (SDTURN), the coefficient of variation in the
Amihud’s illiquidity measure (CVILLIQ), Pastor and Stambaugh’s (2003) liquidity beta (PS), Acharya
and Pedersen’s (2005) four liquidity betas (BETA1–BETA4), and the loadings on the fixed and the
variable components of Sadka’s (2006) liquidity factor (SADKAF and SADKAV). Specifications (1)
and (2) control for the GKM dummy variables (GKMH and GKML ) and the abnormal dollar trading
volume (VOLDU), respectively. Newey-West t-statistics are given in parentheses.
xxiv

Variable Attention measured by LNME Attention measured by CVRG Attention measured by INST
(1) (2) (1) (2) (1) (2)
LIQU 0.908 0.979 0.603 0.572 0.403 0.320
(4.68) (4.80) (6.82) (6.54) (6.79) (5.76)
LIQU×ILLIQ 0.100 0.086 0.100 0.055 0.027 0.003
(1.93) (1.66) (1.07) (0.60) (0.54) (0.06)
LIQU×ATTENTION -0.111 -0.148 -0.180 -0.234 -0.234 -0.304
(-3.34) (-4.12) (-3.11) (-3.94) (-2.01) (-2.56)
BETA 0.154 0.169 0.219 0.229 0.148 0.162
(1.42) (1.58) (1.83) (1.91) (1.38) (1.51)
LNME -0.129 -0.177 -0.062 -0.105
(-2.72) (-3.72) (-1.85) (-3.10)
LNBM 0.143 0.125 0.080 0.063 0.152 0.137
(1.89) (1.67) (0.96) (0.76) (2.04) (1.87)
MOM 0.004 0.003 0.004 0.002 0.004 0.003
(2.71) (1.87) (2.06) (1.41) (2.67) (1.86)
REV -0.035 -0.048 -0.039 -0.050 -0.036 -0.049
(-6.51) (-8.79) (-6.82) (-8.47) (-6.74) (-8.93)
COSKEW 0.199 0.178 -0.012 -0.039 0.260 0.250
(0.25) (0.22) (-0.01) (-0.05) (0.32) (0.32)
IVOL -0.293 -0.371 -0.306 -0.371 -0.289 -0.358
(-6.09) (-7.54) (-5.79) (-6.67) (-6.04) (-7.26)
MAX -0.010 -0.001 -0.027 -0.019 -0.009 -0.001
(-1.03) (-0.12) (-2.43) (-1.75) (-0.99) (-0.09)
DISP -0.06 -0.06 -0.07 -0.07 -0.07 -0.06
(-2.10) (-1.92) (-2.28) (-2.19) (-2.21) (-2.07)
ILLIQ 0.080 0.065 0.301 0.265 0.069 0.050
(3.37) (2.75) (2.62) (2.35) (2.92) (2.15)
CVILLIQ 0.105 0.037 0.207 0.149 0.113 0.053
(1.77) (0.63) (2.81) (2.02) (1.99) (0.93)
SDTURN -0.282 -0.246 -0.266 -0.241 -0.280 -0.244
(-3.04) (-2.72) (-2.87) (-2.64) (-2.99) (-2.68)
PS 0.001 0.001 0.001 0.001 0.001 0.001
(1.22) (1.14) (1.10) (1.06) (1.18) (1.11)
BETA1 0.194 0.196 0.072 0.074 0.194 0.189
(1.02) (1.05) (0.36) (0.37) (1.03) (1.02)
BETA2 -4.399 -3.892 0.809 2.335 -3.350 -2.589
(-1.25) (-1.14) (0.10) (0.28) (-0.97) (-0.76)
BETA3 1.639 1.515 2.440 2.396 1.750 1.632
(1.28) (1.20) (1.62) (1.60) (1.36) (1.28)
BETA4 -0.304 -0.304 0.547 0.534 -0.309 -0.316
(-0.95) (-0.95) (0.92) (0.90) (-0.97) (-1.00)
SADKAF -0.004 -0.004 -0.003 -0.004 -0.003 -0.003
(-1.19) (-1.24) (-0.98) (-1.00) (-1.00) (-1.03)
SADAKV -0.015 -0.015 -0.009 -0.009 -0.015 -0.015
(-1.79) (-1.78) (-0.99) (-0.95) (-1.82) (-1.79)
SUE 0.296 0.281 0.216 0.207 0.295 0.281
(13.92) (13.20) (9.49) (9.04) (13.85) (13.15)
GKMH 0.571 0.514 0.577
(5.92) (4.92) (6.08)
GKML -0.088 -0.092 -0.092
(-1.35) (-1.31) (-1.37)
VOLDU 0.196 0.145 0.176
(9.31) (6.83) (8.67)
ATTENTION -0.071 -0.125 0.145 0.148 0.187 0.163
(-2.23) (-3.90) xxv(2.46) (2.53) (1.00) (0.88)

(1) (2) (1) (2) (1) (2)
SPRDU 1.721 1.650 0.825 0.753 0.788 0.679
(7.37) (7.06) (5.71) (5.26) (6.56) (5.85)
SPRDU×ILLIQ 0.322 0.272 0.019 0.043 0.116 0.057
(3.36) (2.87) (0.09) (0.20) (1.14) (0.55)
SPRDU×ATTENTION -0.228 -0.237 -0.313 -0.335 -0.815 -0.836
(-5.71) (-5.82) (-3.76) (-3.99) (-4.17) (-4.26)
BETA 0.263 0.279 0.345 0.354 0.258 0.272
(2.21) (2.36) (2.47) (2.54) (2.19) (2.32)
LNME -0.084 -0.106 -0.160 -0.183 -0.078 -0.099
(-2.10) (-2.68) (-2.90) (-3.36) (-1.86) (-2.37)
LNBM 0.101 0.089 0.056 0.043 0.107 0.095
(1.23) (1.10) (0.63) (0.49) (1.32) (1.18)
MOM 0.004 0.002 0.004 0.003 0.004 0.002
(2.14) (1.35) (2.00) (1.39) (2.14) (1.36)
REV -0.028 -0.041 -0.030 -0.041 -0.029 -0.041
(-5.37) (-7.86) (-5.25) (-7.07) (-5.53) (-7.99)
COSKEW 0.746 0.718 0.364 0.302 0.777 0.751
(0.89) (0.86) (0.44) (0.37) (0.91) (0.89)
IVOL -0.234 -0.322 -0.243 -0.324 -0.239 -0.325
(-4.12) (-5.50) (-4.05) (-5.03) (-4.19) (-5.50)
MAX -0.017 -0.010 -0.029 -0.023 -0.018 -0.011
(-1.49) (-0.90) (-2.23) (-1.77) (-1.56) (-0.98)
DISP -0.082 -0.075 -0.09 -0.08 -0.08 -0.08
(-2.27) (-2.10) (-2.27) (-2.21) (-2.33) (-2.18)
SPRD -0.019 0.018 -0.124 -0.080 -0.003 0.035
(-0.30) (0.26) (-1.18) (-0.74) (-0.05) (0.54)
ILLIQ 0.183 0.159 0.486 0.433 0.185 0.162
(4.32) (3.94) (2.99) (2.69) (4.48) (4.08)
CVILLIQ 0.124 0.057 0.227 0.156 0.125 0.061
(1.75) (0.80) (2.39) (1.64) (1.78) (0.85)
SDTURN -0.250 -0.192 -0.250 -0.202 -0.233 -0.177
(-2.57) (-2.01) (-2.43) (-2.00) (-2.43) (-1.87)
PS 0.001 0.001 0.001 0.001 0.001 0.001
(0.93) (0.86) (1.00) (0.95) (0.97) (0.91)
BETA1 0.207 0.219 0.117 0.138 0.205 0.216
(0.97) (1.04) (0.50) (0.59) (0.97) (1.04)
BETA2 3.313 3.241 -5.548 -5.362 3.805 3.786
(0.91) (0.90) (-0.78) (-0.76) (1.04) (1.05)
BETA3 3.954 3.885 5.332 5.320 4.066 3.999
(3.33) (3.30) (3.58) (3.59) (3.35) (3.32)
BETA4 -0.132 -0.123 0.516 0.601 -0.164 -0.152
(-0.39) (-0.37) (0.74) (0.86) (-0.49) (-0.47)
SADKAF 0.000 0.000 -0.001 -0.001 0.001 0.001
(0.10) (0.13) (-0.21) (-0.18) (0.17) (0.21)
SADAKV -0.010 -0.010 -0.009 -0.008 -0.010 -0.010
(-1.00) (-0.93) (-0.84) (-0.75) (-1.01) (-0.94)
SUE 0.272 0.251 0.183 0.169 0.272 0.252
(11.39) (10.60) (7.41) (6.87) (11.27) (10.51)
GKMH 0.548 0.513 0.552
(4.99) (4.25) (5.03)
GKML -0.146 -0.157 -0.146
(-2.03) (-1.90) (-1.95)
VOLDU 0.186 0.154 0.179
(8.36) xxvi (6.29) (8.38)
ATTENTION 0.168 0.188 0.134 0.144
(2.72) (3.01) (0.65) (0.71)

(1) (2) (1) (2) (1) (2)
LIQCU 0.329 0.353 0.230 0.216 0.241 0.197
(3.39) (3.62) (3.78) (3.51) (3.87) (3.38)
LIQCU×ILLIQ 0.088 0.081 0.111 0.082 0.092 0.073
(2.45) (2.28) (1.27) (0.93) (2.42) (2.04)
LIQCU×ATTENTION -0.032 -0.046 -0.050 -0.073 -0.237 -0.261
(-1.87) (-2.67) (-1.53) (-2.15) (-1.90) (-2.04)
BETA 0.172 0.188 0.192 0.201 0.167 0.181
(1.55) (1.70) (1.49) (1.57) (1.51) (1.65)
LNME -0.127 -0.173 -0.051 -0.093
(-2.59) (-3.51) (-1.49) (-2.70)
LNBM 0.146 0.120 0.086 0.062 0.154 0.132
(1.93) (1.60) (1.03) (0.75) (2.08) (1.79)
MOM 0.005 0.003 0.005 0.003 0.005 0.003
(3.18) (2.05) (2.61) (1.67) (3.09) (2.00)
REV -0.033 -0.047 -0.037 -0.049 -0.034 -0.048
(-6.08) (-8.54) (-6.27) (-8.23) (-6.29) (-8.70)
COSKEW 0.264 0.232 -0.115 -0.149 0.356 0.330
(0.33) (0.30) (-0.14) (-0.18) (0.46) (0.43)
IVOL -0.279 -0.360 -0.293 -0.366 -0.279 -0.355
(-5.60) (-7.22) (-5.44) (-6.61) (-5.56) (-7.05)
MAX -0.009 0.000 -0.025 -0.017 -0.009 0.000
(-0.91) (-0.02) (-2.24) (-1.50) (-0.89) (-0.01)
DISP -0.08 -0.07 -0.09 -0.08 -0.08 -0.07
(-2.43) (-2.26) (-2.51) (-2.44) (-2.43) (-2.28)
ILLIQ 0.104 0.083 0.262 0.213 0.096 0.074
(3.83) (3.20) (2.49) (2.10) (3.54) (2.84)
CVILLIQ 0.108 0.039 0.241 0.169 0.105 0.040
(1.72) (0.64) (3.14) (2.23) (1.74) (0.67)
SDTURN -0.271 -0.219 -0.250 -0.206 -0.265 -0.212
(-2.90) (-2.40) (-2.71) (-2.27) (-2.83) (-2.33)
PS 0.001 0.001 0.001 0.001 0.001 0.001
(1.32) (1.22) (0.99) (0.92) (1.33) (1.24)
BETA1 0.140 0.144 0.045 0.054 0.131 0.132
(0.69) (0.72) (0.20) (0.25) (0.65) (0.67)
BETA2 -4.907 -4.348 -9.425 -7.990 -3.904 -2.969
(-1.14) (-1.01) (-0.66) (-0.56) (-0.94) (-0.72)
BETA3 2.035 1.855 1.323 1.259 2.154 1.989
(1.46) (1.34) (0.71) (0.68) (1.53) (1.42)
BETA4 -0.559 -0.558 0.501 0.429 -0.588 -0.601
(-1.33) (-1.34) (0.56) (0.48) (-1.40) (-1.44)
SADKAF -0.003 -0.004 -0.002 -0.002 -0.003 -0.003
(-1.10) (-1.13) (-0.56) (-0.57) (-0.87) (-0.88)
SADAKV -0.016 -0.015 -0.012 -0.011 -0.016 -0.015
(-1.77) (-1.70) (-1.13) (-1.05) (-1.78) (-1.71)
SUE 0.304 0.284 0.226 0.212 0.304 0.284
(13.87) (13.12) (9.88) (9.32) (13.92) (13.17)
GKMH 0.533 0.498 0.534
(5.20) (4.54) (5.25)
GKML -0.081 -0.084 -0.082
(-1.20) (-1.19) (-1.19)
VOLDU 0.203 0.170 0.196
(9.27) (7.71) (9.34)
ATTENTION -0.067 -0.117 0.129 0.140 0.147 0.128
(-2.00) (-3.49) xxvii(2.23) (2.43) (0.77) (0.68)

Table A11
Predicting cumulative stock returns
Each month, cumulative excess returns in two to six months into the future are regressed on a set of
predictive variables measured in month t using the Fama and MacBeth (1973) methodology. This table
reports the average slope coefficients of the liquidity shock (SPRDU in Panel A and LIQCU in Panel B)
without interaction terms and with interactions between liquidity shock and ILLIQ and between liquid-
ity shock and an attention variable. The control variables include the market beta (BETA), the natural
logarithm of market capitalization (LNME), the natural logarithm of the book-to-market equity ratio
(LNBM), the momentum return (MOM), the short-term reversal (REV), the co-skewness (COSKEW),
the idiosyncratic volatility (IVOL), the maximum daily return in a month (MAX), the analyst earnings
forecast dispersion (DISP), the standardized unexpected earnings (SUE), the high- and low-volume
dummy variables (GKMH and GKML ), the dollar trading volume shock (VOLDU), the standard devi-
ation of the monthly turnover over the past 12 months (SDTURN), the coefficient of variation in the
Amihud’s illiquidity measure (CVILLIQ), Pastor and Stambaugh’s (2003) liquidity beta (PS), Acharya
and Pedersen’s (2005) four liquidity betas (BETA1–BETA4), and the loadings on the fixed and the
variable components of Sadka’s (2006) liquidity factor (SADKAF and SADKAV). Specifications (1)
and (2) control for the GKM dummy variables (GKMH and GKML ) and the abnormal dollar trading
volume (VOLDU), respectively. For brevity, we suppress the average coefficients of the control vari-
ables, which are available upon request. The t-statistics (in parentheses) are based on Hodrick (1992)
robust standard errors.
xxviii

Panel A1. Without interaction terms
Variable Month 2 Month 3 Month 4 Month 5 Month 6
(1) (2) (1) (2) (1) (2) (1) (2) (1) (2)
SPRU 0.952 0.868 1.242 1.164 1.514 1.449 1.658 1.599 1.829 1.775
(6.33) (5.77) (5.52) (5.17) (4.82) (4.59) (4.07) (3.90) (3.70) (3.55)
Panel A2. Interacting with ILLIQ and LNME

(1) (2) (1) (2) (1) (2) (1) (2) (1) (2)
SPRU 2.798 2.707 3.669 3.573 4.415 4.319 4.819 4.722 5.214 5.119
(6.72) (6.48) (5.69) (5.51) (5.18) (5.05) (4.44) (4.34) (4.02) (3.93)
SPRU×ILLIQ 0.337 0.290 0.428 0.383 0.468 0.431 0.424 0.392 0.434 0.403
(1.82) (1.57) (1.46) (1.30) (1.31) (1.20) (0.92) (0.84) (0.86) (0.79)
SPRU×LNME -0.382 -0.385 -0.499 -0.501 -0.605 -0.603 -0.659 -0.654 -0.718 -0.713
(-5.32) (-5.29) (-4.42) (-4.37) (-4.13) (-4.05) (-3.55) (-3.47) (-3.29) (-3.22)
Panel A3. Interacting with ILLIQ and CVRG

(1) (2) (1) (2) (1) (2) (1) (2) (1) (2)
SPRU 1.307 1.214 1.636 1.532 1.817 1.724 1.770 1.673 1.879 1.787
(5.31) (4.92) (4.29) (4.02) (3.64) (3.47) (2.92) (2.76) (2.58) (2.42)
SPRU×ILLIQ 0.127 0.202 0.166 0.256 0.559 0.601 0.721 0.770 0.776 0.831
(0.34) (0.54) (0.30) (0.46) (0.73) (0.81) (0.77) (0.83) (0.64) (0.71)
SPRU×CVRG -0.486 -0.502 -0.561 -0.568 -0.589 -0.586 -0.530 -0.521 -0.561 -0.554
(-3.35) (-3.43) (-2.49) (-2.50) (-1.93) (-1.90) (-1.39) (-1.36) (-1.25) (-1.22)
Panel A4. Interacting with ILLIQ and INST

(1) (2) (1) (2) (1) (2) (1) (2) (1) (2)
SPRU 1.136 1.030 1.298 1.199 1.396 1.306 1.459 1.377 1.420 1.342
(5.65) (5.05) (4.42) (4.01) (3.60) (3.30) (2.98) (2.79) (2.42) (2.26)
SPRU×ILLIQ 0.024 0.076 0.130 0.180 0.283 0.329 0.434 0.475 0.537 0.577
(0.13) (0.41) (0.47) (0.64) (0.81) (0.93) (0.96) (1.04) (1.08) (1.13)
SPRU×INST -1.128 -1.127 -1.088 -1.087 -1.068 -1.053 -0.980 -0.947 -0.728 -0.704
(-3.13) (-3.08) (-2.04) (-2.01) (-1.53) (-1.50) (-1.04) (-1.00) (-0.65) (-0.63)
xxix

Panel B1. Without interaction terms
(1) (2) (1) (2) (1) (2) (1) (2) (1) (2)
LIQCU 0.222 0.159 0.226 0.168 0.200 0.145 0.226 0.170 0.225 0.165
(6.01) (4.14) (3.47) (2.48) (2.24) (1.58) (1.95) (1.44) (1.56) (1.11)
Panel B2. Interacting with ILLIQ and LNME

(1) (2) (1) (2) (1) (2) (1) (2) (1) (2)
LIQCU 0.320 0.337 0.331 0.345 0.485 0.499 0.478 0.500 0.582 0.605
(2.68) (2.79) (1.95) (2.02) (2.07) (2.13) (1.68) (1.73) (1.58) (1.65)
LIQCU×ILLIQ 0.046 0.040 0.010 0.003 0.029 0.021 0.020 0.013 0.062 0.056
(0.93) (0.80) (0.14) (0.05) (0.34) (0.25) (0.19) (0.13) (0.44) (0.40)
LIQCU×LNME -0.037 -0.047 -0.042 -0.051 -0.074 -0.083 -0.069 -0.080 -0.085 -0.097
(-1.65) (-2.07) (-1.68) (-1.89) (-1.31) (-1.59) (-1.31) (-1.50) (-1.23) (-1.40)
Panel B3. Interacting with ILLIQ and CVRG

(1) (2) (1) (2) (1) (2) (1) (2) (1) (2)
LIQCU 0.278 0.267 0.270 0.263 0.325 0.315 0.274 0.270 0.314 0.308
(3.55) (3.42) (2.06) (2.01) (1.90) (1.85) (1.30) (1.29) (1.25) (1.23)
LIQCU×ILLIQ 0.179 0.154 0.166 0.146 0.158 0.135 0.142 0.120 0.251 0.224
(1.35) (1.17) (0.82) (0.72) (0.70) (0.60) (0.42) (0.36) (0.62) (0.55)
LIQCU×CVRG -0.094 -0.109 -0.103 -0.119 -0.148 -0.164 -0.115 -0.134 -0.123 -0.144
(-2.23) (-2.55) (-1.49) (-1.72) (-1.63) (-1.79) (-1.00) (-1.17) (-0.84) (-0.98)
Panel B4. Interacting with ILLIQ and INST

(1) (2) (1) (2) (1) (2) (1) (2) (1) (2)
LIQCU 0.230 0.202 0.192 0.165 0.208 0.181 0.220 0.191 0.204 0.174
(3.68) (3.26) (2.37) (2.03) (1.93) (1.70) (1.39) (1.22) (1.12) (0.97)
LIQCU×ILLIQ 0.056 0.042 0.013 0.000 0.012 0.002 0.006 0.009 0.018 0.004
(1.12) (0.84) (0.20) (0.00) (0.14) (0.02) (0.06) (0.08) (0.13) (0.03)
LIQCU×INST -0.331 -0.348 -0.254 -0.265 -0.329 -0.338 -0.329 -0.338 -0.234 -0.247
(-2.09) (-2.19) (-1.22) (-1.26) (-1.28) (-1.33) (-0.87) (-0.89) (-0.54) (-0.58)
xxx

Table A12
Bivariate Portfolios of Liquidity Shocks controlling for IVOLU and VOLDU: Two-month ahead
predictability
This table reports the equal-weighted returns and return differences in month t + 2 between High and
Low liquidity shock (SPRDU or LIQCU) quintile portfolios and the alphas after controlling for the
abnormal dollar trading volume (VOLDU) and the idiosyncratic volatility shock (IVOLU). Newey-
West t-statistics are given in parentheses.
Controlling for VOLDU Controlling for IVOLU

Quintile SPRDU LIQCU SPRDU LIQCU
1 (Low) 0.81 0.94 0.74 0.90
2 0.90 1.04 0.95 1.07
3 1.05 1.08 1.04 1.06
4 1.13 1.26 1.10 1.24
5 (High) 1.30 1.45 1.26 1.41
High - Low 0.49 0.51 0.52 0.51
(3.48) (4.22) (3.13) (4.19)
Alpha 0.50 0.44 0.57 0.54
(4.14) (4.81) (4.06) (5.21)
xxxi

Table A13
Results based on quote midpoint returns
Monthly stock returns are calculated based on the quote midpoint, which is the average of the monthly closing national best bid and offer
(NBBO) and adjusted for dividends and stock splits. NBBO data is from the TAQ database. Panel A of this table reports the equal- and value-
weighted one-month ahead quote midpoint returns for decile portfolios formed on liquidity shocks (LIQU, SPRDU, and LIQCU), the return
differentials between High and Low liquidity shock deciles and the corresponding Fama-French (1993) alphas. Panel B reports the average
slope coefficients of liquidity shocks (Liq-shock) from the monthly Fama-MacBeth regressions of one-month ahead excess quote midpoint
returns on liquidity shock and all the other control variables listed in Table 6. Specifications (1) and (2) control for the GKM dummy variables
(GKMH and GKML ) and the abnormal dollar trading volume (VOLDU), respectively. For brevity, we suppress the average coefficients of the
control variables, which are available upon request. Newey-West t-statistics are reported in parentheses.
Panel A. One-month ahead returns for portfolios formed on liquidity shocks

LIQU portfolios SPRDU portfolios LIQCU portfolios
Decile Equal-weighted Value-weighted Equal-weighted Value-weighted Equal-weighted Value-weighted
1 (Low) 0.36 0.20 0.47 0.47 0.53 0.49
xxxii
2 0.68 0.61 0.91 0.56 0.80 0.56
3 0.87 0.74 0.90 0.70 1.02 1.00
4 1.05 1.01 0.82 0.71 1.05 0.93
5 0.99 0.90 0.86 0.72 1.00 0.83
6 0.99 0.99 0.97 0.74 1.06 1.04
7 0.98 1.11 0.90 0.74 1.02 0.88
8 1.12 1.17 0.91 1.03 1.06 0.95
9 1.27 1.12 1.12 1.12 1.11 0.98
10 (High) 1.63 1.43 1.34 1.19 1.37 1.13

High-Low 1.27 1.23 0.87 0.72 0.84 0.64
(5.29) (3.82) (3.92) (2.11) (4.40) (2.33)
Alpha 1.39 1.30 0.91 0.80 0.97 0.79
(6.32) (4.60) (4.64) (2.69) (6.30) (3.84)

Liquidity shock measured by LIQU Liquidity shock measured by SPRDU Liquidity shock measured by LIQCU
(1) (2) (1) (2) (1) (2)
LIQ-shock 0.287 0.274 0.674 0.593 0.161 0.131
(5.47) (5.07) (7.45) (6.49) (5.16) (4.57)
Table A14
Stock-level cross-sectional regressions after correcting for microstructure biases
This table performs modified Fama-MacBeth regressions following Asparouhova, Bessembinder, and
Kalcheva (2010). We estimate monthly weighted least squares (WLS) regressions, where each ob-
served return is weighted by the gross return on the same stock in the prior month. This table reports
the average slope coefficients and Newey-West t-statistics in parentheses. LIQU denotes the liquid-
ity shock, defined as the negative Amihud’s (2002) illiquidity measure (ILLIQ), demeaned using the
past 12-month ILLIQ as the mean. SPRDU is the shock to the monthly volume-weighted effective
relative spread (SPRD), calculated in the same fashion as LIQU. LIQCU denotes the conditional mea-
sure of liquidity shock, defined as the negative of the difference between the realized ILLIQ and the
conditional mean of ILLIQ in the month estimated under the assumption that the conditional mean
of ILLIQ follows an ARMA(1,1) process. BETA, LNME, and LNBM denote the market beta, the
natural logarithm of the market capitalization, and the natural logarithm of the book-to-market equity
ratio, respectively. MOM is the momentum return. REV is the short-term reversal. COSKEW and
IVOL are the co-skewness and idiosyncratic volatility, respectively. MAX denotes the maximum daily
return in a month. DISP measures the analyst earnings forecast dispersion. SUE is the standardized
unexpected earnings. CVILLIQ is the coefficient of variation in the Amihud’s illiquidity measure.
SDTURN denotes the standard deviation of the monthly turnover over the past 12 months. PS is Pas-
tor and Stambaugh’s (2003) liquidity beta. BETA1–BETA4 are Acharya and Pedersen’s (2005) four
liquidity betas. SADKAF and SADKAV are the loadings on the fixed and the variable components of
Sadka’s (2006) liquidity factor. GKMH and GKML denote the high- and low-volume dummy variables.
VOLDU measures the abnormal dollar trading volume.
xxxiii

(1) (2) (1) (2) (1) (2)
LIQ-Shock 0.212 0.181 0.672 0.583 0.184 0.148
(4.59) (4.00) (7.12) (6.63) (5.31) (3.51)
BETA 0.169 0.189 0.265 0.283 0.187 0.204
(1.52) (1.70) (2.11) (2.26) (1.67) (1.83)
LNME -0.060 -0.091 -0.069 -0.085 -0.038 -0.083
(-1.82) (-2.74) (-1.65) (-2.05) (-1.17) (-2.49)
LNBM 0.150 0.134 0.104 0.096 0.158 0.136
(1.90) (1.74) (1.22) (1.13) (2.05) (1.77)
MOM 0.006 0.003 0.004 0.002 0.005 0.003
(3.57) (2.25) (2.20) (1.30) (3.45) (2.25)
REV -0.032 -0.049 -0.027 -0.041 -0.033 -0.048
(-6.25) (-9.35) (-5.15) (-8.02) (-6.27) (-9.11)
COSKEW 0.100 0.097 0.748 0.719 0.263 0.247
(0.12) (0.12) (0.87) (0.85) (0.33) (0.31)
IVOL -0.287 -0.363 -0.210 -0.301 -0.258 -0.337
(-5.74) (-7.11) (-3.38) (-4.63) (-4.93) (-6.43)
MAX -0.016 -0.004 -0.016 -0.008 -0.012 -0.002
(-1.62) (-0.40) (-1.36) (-0.66) (-1.19) (-0.16)
DISP -0.072 -0.065 -0.088 -0.082 -0.082 -0.076
(-2.26) (-2.04) (-2.32) (-2.17) (-2.53) (-2.36)
SPRD 0.013 0.064
(0.18) (0.91)
ILLIQ 0.060 0.039 0.104 0.089 0.080 0.062
(2.21) (1.56) (3.39) (3.05) (3.04) (2.47)
CVILLIQ 0.106 0.036 0.095 0.021 0.121 0.046
(1.74) (0.59) (1.40) (0.30) (1.89) (0.72)
SDTURN -0.252 -0.204 -0.233 -0.170 -0.242 -0.189
(-2.83) (-2.33) (-2.52) (-1.86) (-2.68) (-2.14)
PS 0.002 0.001 0.002 0.001 0.002 0.002
(1.37) (1.25) (1.12) (1.03) (1.53) (1.40)
BETA1 0.142 0.139 0.185 0.187 0.100 0.098
(0.77) (0.77) (0.87) (0.89) (0.51) (0.51)
BETA2 -4.852 -4.048 0.131 -0.081 -5.281 -3.756
(-1.26) (-1.07) (0.03) (-0.02) (-1.20) (-0.88)
BETA3 1.494 1.394 3.764 3.633 1.913 1.745
(1.13) (1.07) (3.02) (2.95) (1.34) (1.23)
BETA4 -0.378 -0.391 -0.392 -0.393 -0.637 -0.640
(-1.10) (-1.14) (-0.89) (-0.91) (-1.52) (-1.54)
SADKAF -0.003 -0.003 0.001 0.001 -0.003 -0.003
(-0.86) (-0.91) (0.26) (0.26) (-0.84) (-0.85)
SADKAV -0.015 -0.015 -0.010 -0.009 -0.015 -0.014
(-1.70) (-1.69) (-0.97) (-0.92) (-1.60) (-1.55)
SUE 0.279 0.259 0.255 0.233 0.280 0.260
(12.70) (11.85) (10.31) (9.48) (12.80) (11.99)
GKMH 0.556 0.516 0.550
(5.78) (4.75) (5.39)
GKML -0.086 -0.156 -0.095
(-1.34) (-2.05) (-1.39)
VOLDU 0.201 0.181 0.195
(9.10) (7.10) (8.72)
xxxiv

SSRN Id2055472

Uploaded by

Copyright:

Available Formats

You might also like

SSRN Id2055472

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

SSRN Id2055472

Uploaded by

Copyright:

Available Formats

Liquidity Shocks and Stock Market Reactions

Turan G. Bali∗ Lin Peng† Yannan Shen‡ Yi Tang§

JEL classification code: G02, G10, G11, G12, G14, C13.

687-5388. Fax: (202) 687-4031.

10010. Email: yannan.shen@baruch.cuny.edu. Phone: (646) 312-3242. Fax: (646) 312-3161.

Fax: (646) 312-8295.

Electronic copy available at: https://ssrn.com/abstract=2055472

JEL classification code: G02, G10, G11, G12, G14, C13.

Electronic copy available at: https://ssrn.com/abstract=2055472

Electronic copy available at: https://ssrn.com/abstract=2055472

(2008), and Hirshleifer, Hsu, and Li (2012)).

following liquidity shocks.

Electronic copy available at: https://ssrn.com/abstract=2055472

for up to six months.

but investor attention is a more dominant factor compared to illiquidity.

Electronic copy available at: https://ssrn.com/abstract=2055472

to this simple, nonparametric measure, we use a parametric methodology to construct a conditional

measure of liquidity shocks using an ARMA(1,1) specification for Amihud’s illiquidity.

similar to those from the changes in the Amihud’s illiquidity measure.

Electronic copy available at: https://ssrn.com/abstract=2055472

results remain significant after controlling for the volatility of liquidity.

remains highly significant.

S&P 500 stocks.

statistically and economically significant.

Electronic copy available at: https://ssrn.com/abstract=2055472

liquidity shocks is distinct from the abnormal volume effect.

proposed in the existing literature.

in predicting the cross section of future stock returns.

Electronic copy available at: https://ssrn.com/abstract=2055472

13F filings for the period of 1980-2010.

2.1. Measures of liquidity and liquidity shocks

Electronic copy available at: https://ssrn.com/abstract=2055472

measure is scaled by 106 .

difference between ILLIQ and its past 12-month average:

ILLIQi,t = α0,i + α1,i ILLIQi,t−1 + α2,i εi,t−1 + εi,t , (3)

estimated from the ARMA(1,1) model in month t, −εi,t in equation (3).9

Electronic copy available at: https://ssrn.com/abstract=2055472

volume-weighted effective relative spread is scaled by 102 .

We construct the stock’s negative spread shock (SPRDU) as:

SPRDUi,t = −(SPRDi,t − AV GSPRDi|t−12,t−1 ), (4)

increase (decrease) in liquidity.

2.2. Control variables

observations for all variables computed from daily data.12

Electronic copy available at: https://ssrn.com/abstract=2055472

order) is used to estimate the book value of preferred stock.

scaled by the absolute value of the average outstanding forecast.

Electronic copy available at: https://ssrn.com/abstract=2055472

subtract its past 12-month average from monthly dollar volume.

We also control for a variety of liquidity-based variables. Following Chordia, Subrahmanyam,

Amihud’s illiquidity measure.

Electronic copy available at: https://ssrn.com/abstract=2055472

the betas of the illiquidity portfolio to stocks that comprise it.

monthly market, size and book-to-market factors.

2.3. Summary statistics

of April 1984 to December 2010 from Ronnie Sadka’s webpage.

Electronic copy available at: https://ssrn.com/abstract=2055472

(when measured by LIQCU) times the corresponding mean.