The role of liquidity in asset pricing : the special case of the Portuguese stock market

Purpose: The aim of this paper is to examine the role of liquidity in asset pricing in a tiny market, such as the Portuguese. The unique setting of the Lisbon Stock Exchange with regards to changes in classification from an emerging to a developed stock market, allows an original answer to whether changes in the development of the market affect the role of liquidity in asset pricing. Design/methodology/approach: The authors propose and compare two alternative implications of liquidity in asset pricing: as a desirable characteristic of stocks and as a source of systematic risk. In contrast to prior research for major stock markets, they use the proportion of zero returns which is an appropriated measure of liquidity in tiny markets and propose the separated effects of illiquidity in a capital asset pricing model framework over the whole sample period as well as in two sub-samples, depending on the change in classification of the Portuguese market, from an emerging to a developed one. Findings: The overall results of the study show that individual illiquidity affects Portuguese stock returns. However, in contrast to previous evidence from other markets, they show that the most traded stocks (hence the most liquid stocks) exhibit larger returns. In addition, they show that the illiquidity effects on stock returns were higher and more significant in the period from January 1988 to November 1997, during which the Portuguese stock market was still an emerging market. Research limitations/implications: These findings are relevant for investors when they make their investment decisions and for market regulators because they reflect the need of improving the competitiveness of the Portuguese stock market. Additionally, these findings are a challenge for academics because they exhibit the need for providing alternative theories for tiny markets such as the Portuguese one. Practical implications: The results have important implications for individual and institutional investors who can take into account the peculiar effect of liquidity in stock returns to make proper investment decision. Originality/value: The Portuguese market provides a natural experimental area to analyse the role of liquidity in asset pricing, because it is a tiny market and during the period studied it changed from an emerging to a developed stock market. Moreover, the authors have to highlight that previous evidence almost exclusively focuses on the US and major European stock markets, whereas studies for the Portuguese one are scarce. In this context, the study provides an alternativemethodological approach with results that differ from those theoretically expected. Thus, these findings are a challenge for academics and open a theoretical and a practical debate.