Time‐varying responses of stock returns to market illiquidity: Stress scenario with regime‐switching framework

We test the time‐varying stock return responses to both expected and unexpected market illiquidity. Using a Markov‐switching methodology on Tunisian market data, we find that expected and unexpected market illiquidity effects on Tunisian small‐cap returns are always negative and stable. But for large caps, unexpected market illiquidity (illiquidity shock) effect on stock returns varies over time across two distinct regimes. In the first regime, illiquidity shocks have small effect on stock returns, whereas in the second regime, this effect rises threefold compared to its magnitude in first regime. The second regime (stress scenario) is short lived and characterized by high volatility. We also find that effect of expected market illiquidity on large cap returns is insignificant. In addition, we investigate the factors that lead to the stress scenario on stock exchange of Tunis. We find that stress scenario is contingent to funding illiquidity and economic distress in Tunisia. Results prove that Tunisian economic distress occurred in the context of subprime crisis and Tunisian political crisis of 2010.