Degree

Master of Science in Finance

Department

Department of Finance

School

School of Business Studies (SBS)

Date of Submission

Spring 2024

Supervisor

Dr. Hilal Anwar Butt, Professor and Chairperson, Department of Finance

Submission Type

Research Project

Document Type

Restricted Access

Pages

ix, 49

Keywords

Contemporaneous Returns, Liquidity Shock, Cross-Sectional Relation, Underreaction, One-Month—Ahead Return

Abstract

This thesis examines the relationship between sudden changes in liquidity (liquidity shocks) and the direction of equities in the Pakistani stocks market, using the methodologies proposed by Bali et al. (2014). Like the findings in the United States markets, the study shows that stocks experiencing positive liquidity shocks exhibit higher returns in the future. This highlights the prevalence of irrational investor conduct, where sudden changes in liquidity of stock are not adequately taken into consideration. The analysis uncovers a significant correlation between abrupt fluctuations in stock liquidity and subsequent returns. The monthly stock returns within the month exhibit a range of 1.84% to 7.38% and have statistical and economic significance. However, when portfolio sorting is conducted on a one month ahead basis, it results in decreased yields that vary from 0.32% to 3.10% in the next month, regardless of the liquidity shock measure or portfolio construction method used. The correlation between the variables persists and retains significance, even after considering various risk variables and stock attributes. The findings indicate that a sudden decrease in liquidity not only leads to an immediate decline in stock returns, but also serves as a predictor of negative stock returns for a three-month period. This suggests that the Pakistani market tends to underestimate the influence of liquidity shocks on individual stocks. This phenomenon is further analyzed by considering two theories: the inadequate response hypothesis, which is based on inattention, and the illiquidity theory. The results support the illiquidity-based inaction theory, suggesting that this inadequate response is more pronounced and statistically important for stocks that generate less investor attention, such as tiny and illiquid stocks.

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