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.