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Liquidity Factors and Prediction Bias of Returns——Based on the Influence of the Microstructure Noise
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TitleLiquidity Factors and Prediction Bias of Returns——Based on the Influence of the Microstructure Noise  
AuthorHuang Wei, Lin Jing, Luo Ronghua and Zhou Mingshan  
OrganizationSchool of Finance, Southwestern University of Finance and Economic 
Key WordsMicrostructure Noise; Prediction Bias; Bias Correction 
AbstractThe effect of liquidity on asset pricing has been a popular research topic for a long time. This study mathematically derives that the microstructure noise biases the OLS estimators of expected (il)liquidity factors in the cross-section asset pricing model. The amount of biases are affected by both true risk premiums and relationships between (il)liquidity factors and the noise. The prediction biases of (il)liquidity factors related to the noise are significant from zero. In contrast, the prediction biases of (il)liquidity factors are insignificant, which are unrelated to the noise. These theoretical findings are examined by empirical tests using the data of stocks listed in A-share main board market during the period of 1998—2011. Meanwhile, both our theoretical and empirical analyses demonstrate that the econometric method of WLS, using the last-term gross returns as weights, can correct the biases easily and efficiently. After the correction, expected (il)liquidity factors can predict stock returns very well. The result of this paper helps us understand the pricing ability of liquidity in our capital market. 
Serial NumberWP326 
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