Liquidity shocks and the negative premium of liquidity volatility around the world

•There is a negative liquidity volatility premium in international equity markets.•Such negative premium is driven by the “omitted” liquidity decrease variable.•The return impact of liquidity decrease varies across markets and over time. We find that liquidity volatility negatively affects stock returns across international markets. This association remains consistent across various liquidity metrics and cannot be attributed to the influence of idiosyncratic volatility. Further analysis shows that the omitted liquidity decrease variable is the key driver of the negative premium of liquidity volatility. Considering the asymmetrical impact of liquidity decrease and increase on future stock returns, stocks displaying high liquidity volatility tend to experience significant liquidity decreases, which lead to lower average returns. Once the liquidity decrease is integrated into the pricing model, the negative return premium of liquidity volatility dissipates. Subsequent analysis underscores that the effect of liquidity decrease on returns is more pronounced in markets and periods characterized by diminished efficiency and heightened arbitrage costs.