The pricing of liquidity risk: Evidence from the Nigerian and South African stock markets
Abstract
This study examines whether an illiquidity premium is priced into the return
process of equities. Specifically, the paper uses a liquidity augmented Fama
and French (2015) five-factor model to test whether liquidity effects are
captured in stock returns. The illiquidity premium is captured using the IML
(illiquid minus liquid) factor which represents a compensating premium
investors require to hold less liquid stocks as compared to more liquid stocks.
The model constructed was tested on the Nigerian and South African stock
markets over an analysis horizon of 2013-2018 with a greater focus on the
Nigerian Stock exchange as it faces considerable liquidity challenges. Results
from the analysis show that liquidity is indeed priced in asset returns with an
average annual illiquidity premium of 2.15% for Nigeria and 0.136% for South
Africa. The coefficients on the liquidity factor also generally proved significant
in explaining asset returns thus confirming the main hypothesis of this study.
The presence of an illiquidity premium increases the cost of equity for the
aforementioned markets hence certain policies that may be implemented to
spur liquidity in these markets include increasing free float requirements for
listed companies and improving trading systems to ensure efficiency and
quick execution of trades.