Effects of Liquidity on Idiosyncratic Risk

Abstract: Abstract In this thesis we examine the link between idiosyncratic risk and liquidity on a sample of European equity covering the last 15 years and consisting of monthly retuns on 120 stocks. This thesis builds heavily upon an article by Speigel and Wang (2005), which demonstrates the relationship between risk and various liquidity measures on the US market. In this study idiosyncratic risk is indirectly estimated and extracted by running OLS regressions on a Fama French Three Factor Model, and once more directly by a EGARCH(1,1) model. The liquidity measures are obtained from a working paper by Lubeck and Sarr (2002). Liquidity in equity is approximated by the variables; Turnover rate, the Amivest ratio and its reciprocal the Amihud ratio. We conclude our research by constructing dynamic portfolios based on the variables risk, liquidity and size which are sorted by quintiles in order to control for the variables corresponding effect on returns.