Liquidity is an important factor in financial markets, but it is not always the first consideration in asset pricing, trading, or risk management. In this post, we examine the importance of liquidity from two different perspectives: its predictive relationship with stock returns and its role in option pricing and hedging.
How Liquidity of Stock Affects Its Future Expected Return
The liquidity of a stock is of concern to traders who want to execute a large order at reasonable prices without making a big impact on the market. A stock liquidity level is, however, also a factor influencing the stock’s expected return. Along this line, Reference [1] examined how a stock’s liquidity volatility affects its future performance.
Findings
-The authors find that liquidity volatility negatively predicts subsequent stock returns across global equity markets.
-The relationship is robust across different liquidity measures, including turnover, the Amihud illiquidity ratio, and the percentage of zero-return days.
-The negative liquidity-volatility premium persists after controlling for other factors, including idiosyncratic return volatility.
-The results show an asymmetric relationship between liquidity changes and returns: liquidity decreases have a substantially stronger negative impact than the positive impact associated with comparable liquidity increases.
-This asymmetry implies that stocks with high liquidity volatility are more exposed to large price declines that are not fully offset by price appreciation following liquidity increases.
-Further analysis indicates that downside liquidity volatility, rather than upside liquidity volatility, drives the negative liquidity-volatility premium.
-The stronger effect of liquidity decreases is consistent with the collateral-constraint mechanism proposed in previous research.
In short, the article pointed out that a stock’s liquidity is important not only because of the issues associated with order execution but also because it affects the future performance of the stock. The negative volatility premium is a universal phenomenon that occurs in the majority of global equity markets and across different liquidity measures. Practically speaking, when a stock’s liquidity decreases, it will likely decline in the following months.
Reference
[1] Feng, Frank Yulin and Kang, Wenjin and Zhang, Huiping, Liquidity Shocks and the Negative Premium of Liquidity Volatility Around the World, SSRN 3930591
Incorporating Liquidity into Option Pricing
Liquidity is an overlooked research area, yet it plays a crucial role in financial markets. Trading system developers often use the bid-ask spread as a proxy for liquidity, but this approach is less effective in the options market.
Reference [2] proposes a method for integrating liquidity into the option pricing model. Essentially, it introduces market liquidity as a variable that can change randomly and affects stock prices through a discounting factor and market liquidity levels.
The paper begins by incorporating a stochastic liquidity variable into the SDE for stock price under the P measure. Here, the liquidity process is modeled as an Ornstein-Uhlenbeck process. The SDE is then transformed into the Q measure in which European options are analytically evaluated using a closed-form characteristic function.
Findings
-The authors develop a European option pricing model that jointly incorporates stochastic volatility, economic cycles, and liquidity risk.
-The model combines Heston stochastic volatility with regime switching to capture economic cycles, while market liquidity follows a mean-reverting stochastic process.
-Stock prices are adjusted using a liquidity discounting factor to account for the impact of liquidity risk.
-A regime-switching Esscher transform is used to obtain risk-neutral dynamics and derive a closed-form European option pricing formula.
-Numerical experiments and sensitivity analysis demonstrate that stochastic volatility, economic cycles, and liquidity risk all have significant effects on option prices.
-Empirical results show that incorporating stochastic liquidity significantly improves model performance compared with assuming constant liquidity.
-The stochastic-liquidity component can also improve hedging responses to liquidity shocks and help mitigate risk.
In short, liquidity is integrated as a discount factor, and the study demonstrates its impact on option prices.
Reference
[2] Xin-Jiang He, Hang Chen, Sha Lin, A Closed-Form Formula for Pricing European Options With Stochastic Volatility, Regime Switching, and Stochastic Market Liquidity, Journal of Futures Markets, 2025; 1–12
Closing Thoughts
Together, these studies highlight the importance of considering liquidity in both asset pricing and risk management. The first shows that liquidity volatility contains predictive information about future stock returns, with downside liquidity changes playing a particularly important role. The second demonstrates that incorporating stochastic liquidity into option pricing significantly improves model performance and can enhance hedging against liquidity shocks.
Overall, liquidity is not merely a trading friction but an important source of information and risk that should be explicitly incorporated into quantitative models.
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