Risk of holding stocks with liquidity sensitive to market uncertainty: evidence from China

We investigate the determinants of stocks’ uncertainty elasticity of liquidity (UEL), whether UEL is priced, and how government officials may use national funds to reduce the UEL risk in China’s A‐shares market. We find that stocks with higher UEL have a smaller market capitalisation, lower stock liquidity, less investor attention, and higher market and liquidity risks. Using data from 2004 to 2018, we show that the highest UEL decile portfolio significantly outperforms the lowest UEL decile portfolio by 0.54 percent per month. Moreover, our results show that UEL provides additional explanatory power for stock returns after we control for a stock’s transaction cost, firm characteristic risks, market risk and liquidity risk. As UEL is an important systematic risk, we hypothesise that government officials will take actions to reduce this risk when the market becomes more volatile. Consistent with our hypothesis, our results show that the ‘national team’ provides liquidity by executing trades opposite to those of other institutional investors during the 2015 stock market crisis in China.