Do stock-level liquidity shocks predict stock returns? - Evidence from the Swedish stock market

Sammanfattning: Adopting a methodology similar to Bali, Peng, Shen and Tang (2014), this essay investigates whether stock-level liquidity shocks predict future returns on the Swedish stock market. Liquidity is measured by the relative bid-ask spread. Portfolios with stocks that experienced positive liquidity shocks yield higher returns than portfolios with stocks that experienced negative liquidity shocks. The mean of the slope coefficient for liquidity shocks was significant in stock-level Fama-MacBeth regressions, controlling for beta, size, book-to-market and liquidity level, meaning that liquidity shocks indeed seem to predict higher future returns. Furthermore, it was found that portfolios sorted on relative bid-ask spread show no clear signs of a liquidity premium, indicating that the relationship between returns and the bid-ask spread shocks could be a correlation without causality.