6. Summary and concluding remarks
This study provides strong evidence that the effect of market volatility on individual stock returns depends on how the liquidity of individual stocks reacts to unexpected changes in market volatility. Specifically, we show that unexpected changes in market volatility exert a greater impact on a stock’s return when its liquidity disappears more sharply in response to volatility shocks, indicating that the inverse relation between market volatility and stock returns is due to not only greater risk premiums but also greater illiquidity premiums associated with higher market volatility.
Prior research shows that market volatility exerts a greater impact on stock liquidity after the regulatory changes that increased the role of public traders, reduced the tick size, and decreased or eliminated the role of market makers. To the extent that stock returns are related to market volatility through their respective link to stock liquidity, these regulatory changes are also expected to increase the sensitivity of stock returns to market volatility. We find evidence that is consistent with this expectation, suggesting that these rule changes may have resulted in a market-wide increase in the equity investment risk and risk premiums. Similarly, we find that stock returns became more sensitive to market volatility with the proliferation of high-frequency trading, suggesting that high-frequency trading may have also increased the aggregate equity investment risk.
