Expected Returns and Markov-Switching Illiquidity
Author | : Tyler R. Henry |
Publisher | : |
Total Pages | : 40 |
Release | : 2007 |
ISBN-10 | : OCLC:1290320664 |
ISBN-13 | : |
Rating | : 4/5 ( Downloads) |
Download or read book Expected Returns and Markov-Switching Illiquidity written by Tyler R. Henry and published by . This book was released on 2007 with total page 40 pages. Available in PDF, EPUB and Kindle. Book excerpt: Recent theoretical models imply that liquidity is fragile: financial markets are liquid in some equilibria and illiquid in others. This paper employs an intuitively appealing Markov-switching regime model to investigate the episodic nature of stock market illiquidity and the intertemporal relation between illiquidity risk and expected stock returns. We introduce a two-state Markov-switching regime model for stock market illiquidity, returns and volatility. We find evidence of a significant illiquidity risk premium; the expected stock return is positively related to the conditional probability of an illiquid regime. By combining the Markov-switching model with a log-linear model for stock returns, we derive a tractable expression for the illiquidity feedback effect. Modeling the illiquidity feedback effect is critical to understanding the relation between realized stock returns, expected returns and Markov-switching illiquidity. We develop a flexible Bayesian Markov chain Monte Carlo (MCMC) approach for estimating and comparing models.