Liquidity and asset pricing: Evidence from the Chinese stock markets

Abstract

We introduce a novel two-factor model, incorporating market and liquidity factors, which outperforms the CAPM and Fama-French factor models when applied to stock market returns in Shanghai and Shenzhen over 2000-2019. We compute the liquidity factor as the return on a liquidity-mimicking portfolio, which we construct simultaneously using two measures of liquidity (one of them capturing liquidity’s trading-quantity dimension, and the other associated with its price-impact dimension). Unlike the CAPM and Fama-French factor models, the advocated two-factor model is able to account for numerous return anomalies, such as size, book-to-market ratio, earningsto- price ratio, cash-flow-to-price ratio, return-on-equity, and volatility. The model’s performance is similar when applied separately to the Shanghai and Shenzhen stock markets. Furthermore, it fares similarly over the 1994-2004 and 2005-2019 sub-periods. This result is somewhat surprising, because liquidity seems likely to have been substantially lower over 1994-2004, as the Chinese markets were noticeably smaller, and the critical market reform aimed at eliminating non-tradable shares by the end of 2006 did not occur until 2005.