Stock Liquidity and Return Predictability; Is There a Connection? (Evidence from an Emerging Market)

This study examines the relationship between stock liquidity and return predictability of 116 publicly-traded firms in Tehran Stock Exchange (TSE). To this end, we constructed a dated-regular frequency of time series with total 40128 stock firm observations. After calculating daily bid-ask spreads and stock returns, the observations were classified based on liquidity into three classes and the return predictability was investigated across different classes using a set of parametric tests. The results exhibit signs of return autocorrelation and non-independence over three liquidity groups. Our findings didn’t show a connection between stock liquidity and market efficiency. The Hurst exponent also revealed mean reversion of returns series across different liquidity classes. We conclude that stock liquid ity doesn’t play a significant role in market efficiency and return predictability of stocks in TSE. In case of TSE as other emerging markets, due to the small number of traders (the need for more trading activity) and low market making activities, both the cost of trading increases and the reaction to stock price information is delayed, resulting in predictability of price /return.