The effects of liquidity level on stock returns: the Nairobi stock exchange evidence.

Abstract

Given the evidence in other developed markets that the level of liquidity affects asset returns, a reasonable hypothesis is that the second moment of; liquidity should be positively related to asset returns, provided agents care about the risk associated with fluctuations in liquidity. Motivated by this observation, this study analyzes the relation between liquidity and stock returns with specific reference to the Nairobi Stock Exchange (NSE). The period under study was taken from the year 2000 to 2002. The study set to accept or reject the hypothesis that there is a relationship between liquidity and stock returns, with liquidity proxied by Trading Volume Activity ratio, since information flow into the market is widely unobservable. Stocks quoted at the market are ranked on the basis of their trading activity ratios and two portfolios of bottom six and top six stocks studied for any correlation with their returns. The study finds that there is no relationship between liquidity and stock returns at a confidence level of 90% and therefore that there is no liquidity premium at the Nairobi Stock Market. This result is in line with Fama's Random Walk Theory which implies that a series of stock price changes at the NSE has no memory. There is therefore a lot of noise at the market. If the lack of relationship between liquidity ~mdreturn is a pointer to inefficient pricing of assets at the NSE then the logical policy implication is ~ identify means of making this market efficient.