Idiosyncratic risk, returns and liquidity in the London Stock Exchange: a spillover approach

In the light of recent evidence that liquidity and idiosyncratic risk may be priced factors in the cross section of expected stock returns and that market capitalization significantly affects investor behavior and liquidity, we explore the interactions between liquidity, idiosyncratic risk and return across time as well as across size-based portfolios of stocks listed in the London Stock Exchange. In a Vector Autoregressive (VAR) analytical framework, we find that volatility spills over from large cap stocks to small cap stocks and vice versa. Volatility shocks can be predicted by illiquidity shocks in both large cap as well as in the small cap portfolios. Illiquidity can be predicted by return shocks in small cap stocks. Finally, we document some evidence of asymmetric liquidity spillovers, from large cap stocks to small cap ones, supporting the intuition that common information is first incorporated in the trading behavior of large-cap investors and the liquidity of large cap stocks and is then transmitted in the trading of small stocks.