Relationship between stock market liquidity and stock returns: a Kenyan context

Abstract

Liquidity risk is a significant factor influencing the performance of company stocks, as investors tended to favor stocks with high liquidity, leading to greater demand in the stock market. Market liquidity, defined as the ease with which assets could be bought or sold without substantially impacting their price, is a critical characteristic of financial markets. While the importance of liquidity in determining stock returns is well acknowledged, its impact in emerging markets, such as Kenya, remained underexplored. To address this gap, this research examined the relationship between stock market liquidity and stock returns within the Kenyan context, focusing on companies listed on the Nairobi Securities Exchange (NSE). The study evaluated two key dimensions of liquidity: the Amihud Illiquidity Ratio, which measures the relationship between absolute stock returns and trading volume, and monthly traded share volumes at the NSE. Using a panel regression model, the study assessed the influence of these liquidity measures on stock returns over the period 2017–2023. The findings contribute to the ongoing debate on the liquidity–returns relationship, offering valuable insights for investment strategies and policy formulation in emerging markets. Furthermore, the analysis highlighted the pivotal role of liquidity in enhancing market efficiency and stability, particularly in the NSE, where liquidity has been identified as a major determinant of market performance.