The Time-varying Relationship between Liquidity and Stock Returns: Evidence from Germany

Abstract

This study investigates the structural relationship between illiquidity and ex-ante returns in the German stock market over time. In line with other authors, we show that illiquidity is still a significant factor, but has had a weakened impact in more recent times. When considering structural breaks, illiquidity is not priced during times of financial turmoil, which explains the weakened relationship between illiquidity and returns in the recent past. Incorporating structural breaks in portfolio decisions results in significantly better portfolio returns explained by increasing illiquidity premia. The results are robust to different variations of Amihud’s illiquidity measures and when controlled for Fama-French factors.