Examining the relationship between market liquidity and equity returns - a case study of firms listed on the Nairobi Securities Exchange

Abstract

This study uses a panel regression of 42 actively traded equities listed on the Nairobi Securities Exchange over 58 days to relate a stock's bid-ask spread and its return. The study results show that in the NSE, there is no significant relationship between a stock's bid-ask spread and its return in both the conventional regression sense and the Granger Causality sense. This result leads us to believe that the state of liquidity, as measured by the bid-ask spread of a stock, has no effect on the returns of a stock. Investors therefore do not include a liquidity premium, as measured by the bid-ask spreads, in their prices. This information is useful for both market regulators and market makers. Regulators require another measure of liquidity in order to properly quantify the effect that market liquidity has on the prices of stocks in the market while market makers may demand large spreads and have no effect on the returns of the stocks.