Deciphering Liquidity Risk on the Istanbul Stock Exchange

This paper examines the impact of illiquidity and liquidity risk on expected stock returns in the Turkish stock markets. Using daily data of the ISE-100 stock index from 2005 to 2012 and Amihud (2002) illiquidity measure, we test the liquidity-adjusted capital asset pricing model (L-CAPM) of Acharya and Pedersen (2005). Performing cross-sectional regression tests across test portfolios, we find supporting evidence that illiquidity is significantly and positively priced. Specifically, our results indicate that liquidity risk arising from the commonality in liquidity is the most important component of liquidity risk. The strong interrelationship between the market liquidity and the liquidity of individual stocks suggests that market-wide shocks on the Istanbul Stock Exchange might quickly affect every stock in this market. Hence, liquidity commonality might create a systemic risk in which case liquidity shocks can be perfectly correlated across all stocks. Our study is the first to investigate stock liquidity-return relationship at daily frequency and to apply the L-CAPM on the Turkish stock markets. Our findings provide interesting conclusions for investors, risk managers and regulators in emerging economies, and in particular, Turkey. Investors should incorporate liquidity risk into their trading and hedging strategies to improve their risk profile and increase their investment returns. Furthermore, an improved understanding of systemic liquidity is vital for regulatory authorities to design improved regulations against systemic shocks.