Journal of Banking & Finance 35 (2011) 22172230

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Journal of Banking & Finance

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Liquidity and asset pricing: Evidence from the Hong Kong stock market
Keith S.K. Lam , Lewis H.K. Tam
Department of Finance and Business Economics, Faculty of Business Administration, University of Macau, Av. Padre Tomas Pereira, S.J. Taipa, Macao, China

a r t i c l e i n f o a b s t r a c t

Article history: This study investigates the role of liquidity in pricing stock returns in the Hong Kong stock market.
Received 10 June 2010 Our results show that liquidity is an important factor for pricing returns in Hong Kong after taking
Accepted 17 January 2011 well-documented asset pricing factors into consideration. The results are robust to adding portfolio
Available online 22 January 2011
residuals and higher moment factor in the factor models. The results are also robust to seasonality,
and conditional-market tests. We also compare alternative factor models and nd that the liquidity
JEL classication: four-factor model (market excess return, size, book-to-market ratio, and liquidity) is the best model to
G12
explain stock returns in the Hong Kong stock market, while the momentum factor is not found to be
G15
priced.
Keywords: 2011 Elsevier B.V. All rights reserved.
Liquidity
Asset pricing
Hong Kong stock market
Factor model
Fama French three factors
Higher moment
Momentum

1. Introduction Motivated by these studies, we address the question of

Investors face liquidity risk when they transfer ownership of
their securities. Therefore, investors consider liquidity to be an
important factor when making their investment decisions. Amihud
and Mendelson (1986) nd a positive return-illiquidity relation.
Since that study, many other researchers continue to investigate
the return-illiquidity (liquidity) relation, but evidence over the
past two decades is generally inconsistent and mixed.1
Amihud (2002) shows that there is a signicant relation be-
tween liquidity and expected stock returns. He nds a negative re-
turn-liquidity relation even in the presence of size, beta, and
momentum. The use of time-series models is important, because
it allows for an investigation of whether mimicking portfolios for
risk factors captures shared variation in stock returns and identi-
es whether the model is well-specied.
Corresponding author. Tel.: +853 8397 4167; fax: +853 2883 8320.
E-mail addresses: keithlam@umac.mo (K.S.K. Lam), lewistam@umac.mo (L.H.K.
Tam).
1
Some studies nd evidence supporting the liquidity premium theory (e.g.,
Amihud and Mendelson, 1986; Datar et al., 1998; Amihud, 2002; Chan and Faff, 2005),
while other studies nd inconsistent results (e.g., Fama and French, 1992; Brennan
and Subrahmanyam, 1996; Eleswarapu and Reinganum, 1993). At market level,
Gibson and Mougeot (2004) document a negative relation between return and
liquidity, consistent with the liquidity premium theory.
whether liquidity is an important variable to capture the shared
time-series variation in stock returns by investigating whether
the effect of liquidity on stock return remains after controlling
for the well-known stock return factors using Hong Kong data.
These well-documented factors are beta, size, and book-to-
market ratio factors (the FamaFrench three factors), momentum
factor, and the higher moment (coskewness) factor. Although
these are well-known factors and determinants in explaining
stock returns in the US market, previous studies seldom
examine their joint effect with liquidity in emerging and Asian
markets.2
Gathering out-of-sample evidence to support results beyond
the US market is important in avoiding the data-snooping problem
pointed out by Lo and MacKinlay (1990). Besides, the US market is
arguably the most liquid market in the world, with a smaller
liquidity effect than those of emerging or volatile markets. Investi-
gating the Hong Kong stock market, an important stock market
that ranked seventh in the world by market capitalization at the
2
Lagoarde-Segot (2009) documents a wide divergence in liquidity, informational
efciency, market volatility and transaction costs across emerging markets. The paper
relates these time-varying microstructure features to nancial reforms in emerging
markets but it does not examine the relation between return and liquidity.

0378-4266/$ - see front matter 2011 Elsevier B.V. All rights reserved.
doi:10.1016/j.jbankn.2011.01.015
2218 K.S.K. Lam, L.H.K. Tam / Journal of Banking & Finance 35 (2011) 22172230
end of 2008, can help us understand the impact of liquidity on as-
set pricing in emerging markets because the Hong Kong market is
known to be one of the most volatile stock markets in the world
and it is also well known to be dominated by small rms.3 Thus,
Hong Kong is an ideal out-of-sample testing ground for the return-
liquidity relation because liquidity (illiquidity) should affect ex-
pected returns of many listed rms there.
In this paper, we adopt a time-series regression approach to
study the return-liquidity relation in Hong Kong. Previous stud-
ies do not adequately address the relations among liquidity
and other important asset pricing factors in the Hong Kong
and Asian stock markets. We hope that by studying a highly vol-
atile market such as Hong Kong, we can nd better and more ro-
bust results on the return-liquidity (illiquidity) relation, which
helps to shed light on this issue in the literature. We employ
nine widely used liquidity (illiquidity) proxies in our study. We
adjust stock returns by the three-moment CAPM, the Fama
French three-factor model, and the augmented FamaFrench
three-factor models. Thus, we address the importance of liquidity
together with other known, important time-series determinants
of stock returns, such as beta, size, book-to-market ratio, and
momentum.
Our results show that liquidity is an important factor pricing
returns in Hong Kong after taking into consideration well-
documented asset pricing factors. In particular, illiquid stocks
have positive loadings while liquid stocks have negative loadings
on the liquidity factor. We check the robustness on liquidity by
investigating portfolio residuals and coskewness (higher mo-
ment) for possible missing factors, and by performing seasonality
and conditional-market tests. We also perform multivariate
regressions on all related factors and nd that the best model
is a liquidity four-factor model that includes excess market re-
turn, and factors for size, book-to-market ratio, and liquidity.
But unlike ndings for the US market, the momentum factor
is not an important risk factor for the Hong Kong stock
market.
The rest of this paper is organized as follows. Section 2 reviews
and summarizes the literature on the return-illiquidity (liquidity)
relation. Section 3 describes the data and methodologies. Section
4 presents and analyses the empirical results. Section 5 concludes.
2. Literature review
Amihud and Mendelson (1986) conduct a pioneering study to
investigate the role of illiquidity (liquidity) in asset pricing using
the bid-ask spread as a proxy for illiquidity. They document a po-
sitive relation between expected return and illiquidity. Eleswarapu
and Reinganum (1993) re-examine Amihud and Mendelsons
study using an updated period and nd that the positive return-
illiquidity relation is mainly limited to January. Brennan and
Subrahmanyam (1996) examine the liquidity premium and nd
a positive return-illiquidity relation even after taking price, size,
and book-to-market factors (i.e., the Fama and French (1993) risk
factors) into account. Their results generally support Amihud and
Mendelsons ndings, but refute those of Elsewarapu and
Reinganum.
Peterson and Fialkowski (1994) and Brennan and Subrahmanyam
(1996) raise concerns about the bid-ask spread being a poor proxy
for liquidity. This leads to the use of alternative measures of liquid-
ity, such as trading volume (Brennan et al., 1998), turnover ratio
(Datar et al., 1998; Chan and Faff, 2005), standard deviations of
3
We discuss and compare the volatility in the Hong Kong and US markets under
Section 4 (Test Results).
the turnover ratio and of trading volume, and the coefcients of
variation of the turnover ratio and of trading volume (Chordia
et al., 2001), the Pastor and Stambaugh (2003) liquidity measure
(Ho and Hung, 2009), the Amihud (2002) illiquidity ratio
(Lagoarde-Segot, 2009; Jankowitsch et al., 2011), and the Liu
(2006) liquidity ratio. In general, these studies support Amihud
and Mendelsons (1986) ndings. Our study adopts all those nine
measures to examine the return-liquidity relation in the Hong
Kong stock market.
Recent studies shift away from liquidity as a characteristic of a
stock to liquidity as an aggregate risk factor. Jacoby et al. (2000),
for example, develop a one-period, CAPM-based model to show
that the true measure of systematic risk is based on net (after
bid-ask spread) returns when liquidity costs are considered.
Acharya and Pedersen (2005) decompose Jacoby et al.s liquidity-
adjusted beta into four components and nd that their model sig-
nicantly improves the performance of a traditional CAPM. Pastor
and Stambaugh (2003) nd that stocks with higher sensitivity to
the market-wide liquidity factor yield higher required returns than
stocks with lower sensitivity.
Keene and Peterson (2007) investigate the return-liquidity rela-
tion with updated data and nd evidence in support of Amihud and
Mendelson (1986). They nd that liquidity remains an important
factor even after controlling for the effects of market, size, book-
to-market equity, and momentum. Nguyen et al. (2007) examine
the role of liquidity on returns after taking into account the effects
of the three-moment CAPM, the three-factor FamaFrench CAPM,
and Pastor and Stambaugh (2003) factors. Their ndings support
those of Amihud and Mendelson in that liquidity plays an impor-
tant role in pricing returns even after taking all the factor models
into account. Liu (2006) develops a new proxy measure and shows
that liquidity is an important source of priced risk. He proposes a
two-factor (market and liquidity) model that explains well the
cross-sectional stock returns after controlling for well-documented
stock determinants. In addition, it is capable of accounting for the
book-to-market effect that the FamaFrench three-factor model
cannot explain.
For emerging and Asian markets, Bekaert et al. (2007) study 18
emerging stock markets and nd that liquidity is priced in these
markets. Chan and Faff (2005) and Limkriangkrai et al. (2008)
investigate Australian stock markets and nd that liquidity does af-
fect stock returns. Chung and Wei (2005) nd that there is a posi-
tive relation between holding periods and bid-ask spreads in
Chinese stock markets and support Amihud and Mendelsons
(1986) argument. In general, existing studies nd a positive
return-illiquidity relation in emerging markets.
3. Data and methodologies
3.1. Data
We collect all data used in this study from the Pacic-Basin
Capital Markets (PACAP) Databases compiled by the University of
Rhode Island. The data set contains 769 companies listed on the
Hong Kong Stock Exchange from July 1981 to June 2004.4 Following
previous studies, we include only monthly return data on non-nan-
cial companies with appropriate adjustments for capital changes.
We use value-weighted market returns with cash dividends rein-
vested as a proxy for market returns. For the risk-free rate, we use
the one-month Hong Kong prime rate from January 1981 to June
4
Before 2 April 1986, Hong Kong had four stock exchanges: the Far East Stock
Exchange, the Hong Kong Stock Exchange, the Kam Ngan Stock Exchange, and the
Kowloon Stock Exchange. Since then, the four exchanges have unied into a new one.
The Stock Exchange of Hong Kong Ltd. (SEHK) is now the only stock exchange in Hong
Kong.
 K.S.K. Lam, L.H.K. Tam / Journal of Banking & Finance 35 (2011) 22172230
1988 and the one-month Hong Kong Interbank Offer Rate (HIBOR)
from July 1988 to December 2004.5,6
3.2. Methodologies
The motivation for conducting a time-series test is to examine
whether the asset pricing model, which includes factors for size,
book-to-market, and liquidity, can explain most of the time-series
variations in stock returns. If liquidity is priced, the time-series
intercept will be jointly equal to zero after controlling for the
liquidity factor. Following Nguyen et al. (2007), Gu and Huang
(2010), and Hwang et al. (2010), we use the test developed by
Gibbons, Ross, and Shanken (GRS, 1989) to check whether the
intercepts are jointly equal to zero.7
We construct 25 portfolios for each year using Hong Kong stock
data. We form three sets of portfolios based on (1) size and one of
the liquidity proxies, (2) book-to-market ratio (BM) and one of the
liquidity proxies, and (3) one of the liquidity proxies only. We use
nine liquidity proxies in this study and they are used only once
each time when forming the portfolios. See Appendix A for detailed
descriptions of how the liquidity proxies are constructed. To form
the 25 size-liquidity portfolios, at the end of June every year, we
rank the stock data yearly by market capitalization and divide
the sample into ve equal-size portfolios. Independently, we calcu-
late the annual respective liquidity proxy for each stock in the sam-
ple and assign each stock to ve liquidity portfolios. Twenty-ve
portfolios are then formed by an intersection between the size
groups and liquidity groups. After forming portfolios using the size
and liquidity proxies, we repeat the portfolio-formation procedure
using the book-to-market ratio and liquidity proxies. To form the
25 liquidity portfolios, at the end of June every year, we calculate
the annual respective liquidity proxy for each stock in the sample
and assign the stock to one of the 25 equal portfolios according to
its rank of liquidity. After forming the three sets of portfolios, we
compute the portfolios equally-weighted monthly returns. The ex-
cess portfolio return is the portfolio return minus the risk-free rate
from. We rebalance the portfolios at the end of June every year
from 1981 to 2003. Following Keene and Peterson (2007) and
Nguyen et al. (2007), we use turnover ratio as our main proxy for
liquidity and report our results given by the stock portfolios and
liquidity factors formed by turnover ratio. We will discuss the
5
We use two different return rates because the HIBOR is not available from PACAP
before July 1988. Owing to data unavailability, Chui and Wei (1998) and Daniel et al.
(2001), in their studies of cross-section of stock returns in ve Pacic-Basin stock
markets and in Japan, respectively, use more than one return rate as the risk-free rate
during their sample periods. It is not uncommon to encounter difculties in nding
continuous risk-free rates in Asian markets that are comparable to the US Treasury
Bill rates.
6
In a robustness check, we re-run the model by using prime rate only for the whole
sample period. The results are essentially unchanged compared to those reported in
the paper. Although the prime rate is generally higher than the HIBOR and this results
in a lower stock return premium, the effect is offset by a corresponding decrease in
the stock market premium. The overall effect is that the regression intercepts are only
a few basis points lower and the coefcients of the liquidity factors are also
essentially unchanged.
7
Theoretically, if a particular asset pricing model captures all the factors that affect
stock returns, the intercepts of the 25 time-series portfolio return regressions should
be jointly equal to zero. Previous studies use a variety of tests to determine whether
the intercepts of time-series portfolio return regressions are all zero. Examining the
CAPM, Black et al. (1972) report only univariate t-statistics of each equation but do
not examine the joint signicance of those univariate tests. Gibbons et al. (1989) nd
that while standard tests such as Wald, likelihood ratio, and Lagrange multiplier tests
all are asymptotically distributed as chi-square with N (the number of portfolios)
degrees of freedom as the number of period, T, approaches innity, they produce
biased statistics as N is close to T. They provide an F-test that has a tractable small
sample property. Essentially, the test statistics compare (1) the Sharpe ratio of the ex
post optimal portfolio generated by market proxy plus all the 25 stock portfolios with
(2) the Sharpe ratio of the market proxy alone. Gibbons et al. then extend their tests to
multi-factor models.
2219
results given by the liquidity factors formed by other liquidity
proxies in Section 4.4.
We test the well-documented three-moment CAPM, Fama
French three-factor model and the liquidity-augmented three-fac-
tor model, along with a ve-factor model that includes both the
momentum and liquidity factors. Ordinary least squares (OLS)
time-series regressions are estimated for each of the 25 portfolios
on the factor models.
The three-moment CAPM was rst derived and tested empiri-
cally by Kraus and Litzenberger (1976).8 Recent studies also show
that conditional skewness and higher-order comoments help explain
the cross-sectional variation of stock returns (Harvey and Siddique,
2000; Chen et al., 2001). These ndings lead to the pertinent ques-
tion of whether coskewness risk captures liquidity. Therefore, we
conduct a test by including the higher moment factor, coskewess,
into the traditional CAPM. We also test the FamaFrench three-fac-
tor model which includes market excess return, a size factor and a
book-to-market factor, and three-factor models augmented with a
liquidity factor and/or a momentum factor. Those models are pre-
sented as follows in Eqs. (1)(4):
Rpt  Rft ap bp MP t up MPt  MP2 ept 1
Rpt  Rft ap bp MP t sp SMBt hp HMLt ept 2
Rpt  Rft ap bp MP t sp SMBt hp HMLt wp LIQ t ept 3
Rpt  Rft ap bp MP t sp SMBt hp HMLt wp WMLt wp LIQ t ept
4
where (Rpt  Rft) is portfolio excess returns; MPt is market excess re-
turn; MPt  MP2 is coskewess; MP is the time-series average of
MPt, SMBt is the size factor; HMLt is the book-to-market factor;
WMLt is the momentum factor; LIQt is the liquidity factor; ept is
an error term assumed to have a zero mean and to be uncorrelated
with all other explanatory variables; and the factor sensitivities or
loadings, bp, up, sp, hp, wp, and wp are the slope coefcients in the
time-series regressions for MP, MPt  MP2 , SMB, HML, WML, and
LIQ factors.
The liquidity factor (LIQ) is constructed as follows. Take the
liquidity factor given by turnover ratio (LIQ1) as an example. At
the end of each June, rms are sorted by size (market capitalization)
and included in two portfolios (Small (S) and Big (B)). The same
stocks are independently sorted into three portfolios according to
their turnover ratio (L1 (most illiquid), L2, and L3 (most liquid)).
Six portfolios (S/L1, S/L2, S/L3, B/L1, B/L2, and B/L3) are then formed
at the intersection of size and turnover ratio. The equally-weighted
monthly returns on the six portfolios are calculated each month
over the 12 months following portfolio formation.9 Repeating this
procedure for every year results in 276 equally-weighted monthly re-
turns from July 1981 to June 2004 for each of the six portfolios. LIQ1 is
the simple average of the returns on the low-liquidity portfolios
minus the returns on the high-liquidity portfolios:
S=L1  S=L3 B=L1  B=L3
LIQ1 :
2
We calculate liquidity factors based on other liquidity measures
(LIQ2LIQ9) in the same manner. The construction of the Fama
French three factors and the momentum factors (MP, SMB, HML
8
Kraus and Litzenberger argue that risk-averse investors who want to maximize
their expected utility would choose higher expected return to lower, lower variance
to higher variance, and higher (and positive) than lower (and negative) coskewness.
Therefore, investors are willing to accept a lower expected return for higher positive
coskewness if the market is also positively skewed.
9
We are aware of other studies that calculate value-weighted returns to the six
size-liquidity portfolios for the construction of the liquidity factor (e.g., Keene and
Peterson, 2007; Nguyen et al., 2007). Our results are robust to this alternative way to
form liquidity factors. The results will be available upon request.
2220 K.S.K. Lam, L.H.K. Tam / Journal of Banking & Finance 35 (2011) 22172230

and WML) follows those of the Fama and French (1993) and Lher
et al. (2004). See Appendix B for the details of the formation of those
non-liquidity factors.
Our motivation for conducting a time-series test is to examine
whether or not liquidity has effect on expected stock returns.
Our null hypothesis is that if liquidity is not priced in the Hong
Kong stock market, factor models without liquidity factors (i.e.
FamaFrench three-factor model, or four-factor model) should
capture all the time-series variation in portfolio returns and the
intercepts in these time-series regressions should be jointly equal
to zero. We use the GRS F-test to check whether the intercepts
Table 1
Descriptive statistics of size-liquidity sorted and BM-liquidity-sorted portfolios July
1981June 2004. At the end of July of each year, all Hong Kong-listed rms in PACAP
are sorted according to their market capitalization (size), book-to-market ratio of
equity (BM) and stock turnover ratio (liquidity). Firms are then ranked into quintiles
independently by size and liquidity, or BM and liquidity. Twenty-ve two-way sorted
portfolios are then formed by the intersection of the size-quintile and liquidity-
quintile portfolios (Panel A) or the BM-quintile and liquidity-quintile portfolios (Panel
B). Average size, BM and liquidity of component rms are calculated for each of the 25
two-way sorted portfolios. Each number reported on the table is the yearly time-
series average values of size, BM or liquidity of one of the 25 two-way sorted
portfolios. Panel C reports the annual time-series average numbers of rms in the 25
two-way sorted portfolios.

are jointly equal to zero. The alternative hypothesis is that if Size Liquidity Avg. of size Avg. of book-to-market Avg. of liquidity
liquidity is priced, the intercepts from these regressions without Panel A
liquidity factors will be positive for illiquid stocks and negative 1 1 114,391.64 1.99176 0.5527
for liquid stocks and they should be jointly different from zero. 2 114,283.29 2.03040 1.5966
But such difference will be reduced after controlling for the 3 116,548.72 2.62391 3.0897
4 115,382.65 2.23654 5.9012
liquidity factor in these time-series regressions. By testing these
5 121,531.60 2.21641 15.3443
hypotheses, we are able to search for a suitable asset pricing model
2 1 264,666.22 1.81262 0.5484
for the Hong Kong stock market.
2 272,705.69 1.75781 1.6267
Finally, we perform several robustness tests on the best model 3 272,679.78 1.44158 3.0878
we found. First, we check whether major factors are left out of 4 268,699.81 1.68771 5.7456
the model by including the residual variance and higher moment 5 273,926.34 2.51235 15.6152
(coskewness) in the model. We then examine whether the results 3 1 542,260.78 1.94099 0.5289
are affected by seasonality (such as January effect), market condi- 2 553,114.52 1.67627 1.6228
3 542,934.61 1.62080 3.1040
tions, and the unication of four stock exchanges into one in 1986.
4 528,977.52 1.55792 5.8655
Finally, we investigate whether the model is robust to alternative 5 535,628.06 1.74428 17.3872
ways to form the liquidity factors.
4 1 1,246,127.72 1.65387 0.5600
2 1,230,993.40 1.65076 1.5894
4. Test results 3 1,233,593.27 1.48708 3.0691
4 1,224,016.63 1.42894 5.8389
5 1,190,405.07 1.45900 15.7223
4.1. Descriptive statistics and correlations
5 1 9,206,357.98 0.96726 0.5784
2 14,526,833.59 1.02612 1.6301
Appendix C displays time-series market volatilities for the 3 20,832,067.16 1.08745 3.1179
Hong Kong and the US stock markets over the period from January 4 10,705,828.04 1.33815 5.5453
1980 to December 2003. The Hong Kong stock market return is 5 5,590,069.40 1.47945 15.2641
proxied by the PACAP value-weighted market return with cash
Panel B
dividend reinvested while the US market return is proxied by
1 1 4,836,294.65 0.34564 0.6099
S&P 500 Composite Index return. Following Zhang (2010), market 2 10,626,148.85 0.33641 1.5959
volatility (annualized) in month t is calculated based on the sum of 3 11,125,136.66 0.32354 3.1462
 P 0:5
4 4,232,327.20 0.30436 5.8562
squared returns in the month and is dened as: 12 Dd1 t
mret2td ,
5 1,207,087.02 0.33278 15.1849
where mret is market return, and Dt is the number of trading
2 1 2,418,016.95 0.73296 0.6108
day in month t.
2 5,185,827.44 0.73543 1.6422
The dotted line shows the time-series variation of the Hong 3 6,996,477.95 0.71327 3.0558
Kong market volatility and shaded area shows the variation of US 4 4,492,667.11 0.72621 5.7403
market volatility. The Hong Kong stock market is always more vol- 5 1,757,344.61 0.73010 17.3840
atile than the US market, except from April 2002 to June 2003 3 1 1,006,451.99 1.21893 0.5274
when the US market is more volatile. Over the sample period, 2 2,358,680.24 1.22313 1.6015
3 4,145,306.26 1.19297 3.1203
the average volatility (annualized) of the Hong Kong stock market
4 2,400,640.02 1.18989 5.7118
is 24.0%, almost 60% higher than that of the US stock market, which 5 1,355,920.48 1.21475 13.9596
is 15.1%. In a robustness check, we use CRSP value-weighted port-
4 1 783,343.45 1.92894 0.5289
folio return to proxy for the US market return and the nding is 2 2,174,625.98 1.91610 1.5974
essentially the same. 3 3,616,172.57 1.88967 3.0548
To save space, we only report results using the turnover ratio as 4 1,798,831.91 1.87413 5.5564
a liquidity proxy to construct the size-liquidity (BM-liquidity) port- 5 1,211,083.41 1.92608 16.3174

folios. Table 1 presents descriptive statistics on the 25 portfolios. In 5 1 761,834.92 3.83377 0.5393
Panel A, under size- and liquidity-sorted portfolios, we observe 2 1,164,822.64 3.84092 1.6417
3 1,416,600.99 4.93753 3.0936
that, for small rms, the average size of the rm varies positively
4 1,805,274.26 4.08461 5.8593
with liquidity. For other-size rms, however, the relation between 5 869,355.02 4.56782 16.3736
size and liquidity is mixed. If the portfolios are sorted by BM and
Liquidity rank Size rank
liquidity (Panel B), we also nd no obvious relation between size
1 2 3 4 5
and liquidity. Similarly, we nd no obvious relation between BM
and liquidity after BM is controlled for. Therefore, if we nd that Panel C
1 15.70 13.04 10.74 11.00 7.87
liquidity has a signicant impact on stock return after size and
2 12.17 12.57 11.43 10.04 12.96
BM effects are controlled for, the liquidity effect is unlikely to be 3 10.43 9.96 11.22 11.61 15.61
related to size and BM.
 K.S.K. Lam, L.H.K. Tam / Journal of Banking & Finance 35 (2011) 22172230 2221

Table 1 (continued) In general, all averages of the liquidity factor premiums are
Liquidity rank Size rank
higher than those reported by Keene and Peterson (2007) for the
US market except the two coefcient-of-variation (CV) measures.
1 2 3 4 5
For example, turnover-liquidity factor premium (LIQ1) is 1.28%
4 10.91 11.04 11.91 12.04 13.74 for Hong Kong but only 0.17% for the US (Keene and Peterson,
5 9.83 12.39 13.52 14.43 8.91
2007). The higher liquidity factor premiums in Hong Kong than
BM rank those in the US suggest that Hong Kong investors are more con-
1 7.61 9.09 13.30 14.78 13.57 cerned with liquidity than are US investors.
2 10.39 11.52 12.87 12.30 12.09 Table 3 reports the correlations between the explanatory vari-
3 13.26 12.52 11.48 11.83 9.74
ables. Panel A reports the correlations for the nine liquidity factors
4 12.22 13.83 10.96 10.39 11.78
5 14.87 12.26 10.13 9.87 11.57 (LIQ1LIQ9) while Panel B reports the correlations for the turnover-
liquidity factor (LIQ1) and the other non-liquidity factors. Several
observations are noteworthy. First, in Panel A, the liquidity mea-
Panel C presents the average number of stocks for each of the 25 sures are highly correlated with each other, similar to those found
size-liquidity (BM-liquidity) portfolios. It shows that, on average, in Keene and Peterson (2007). Our results show that most of the
big, illiquid portfolios; big, liquid portfolios; and small, liquid port- correlations are positive (75% or 27 out of 36 correlations). Twenty
folios have fewer rms than small, illiquid portfolios. Low BM, illiq- of the positive correlations (74.07%) are statistically signicant at
uid portfolios have much fewer rms compared to low BM, liquid the 5% level. Within the twenty signicantly positive correlations,
portfolios; and high BM, illiquid portfolios. fourteen of them have values greater than 0.50 with two of the cor-
Table 2 provides descriptive statistics of the explanatory vari- relations have values as high as 0.9539 and 0.9014 respectively.
ables in the time-series regressions. The average value of the mar- Second, the nine negative correlations are all associated with
ket excess return is 1.19% per month (t = 2.25), which is much liquidity factors given by the CV of turnover (LIQ5), the CV of trad-
higher than those in the United States (0.41% for Keene and ing volume (LIQ6) and Pastor and Stambaughs (2003) measure
Peterson (2007) and 0.43% for Fama and French (1993)). The high (LIQ7), with six of them signicant at the 5% level. This suggests
market excess return in the Hong Kong stock market is consistent LIQ5, LIQ6 and LIQ7 may not be good proxies for the liquidity factor.
with the nding that Hong Kong is a highly volatile market. The Third, in Panel B, all factors are signicantly correlated with liquid-
average monthly premium for the book-to-market factor (HML) is ity measures, except WML. MP, SMB and HML are signicant and
0.83% (t = 2.94), which is close to twice the amount reported in the negatively correlated with LIQ1 while MPt  MP2 is signicant
US market (Keene and Peterson (2007) and Fama and French (1993) and positively correlated with LIQ1. However, the magnitudes of
report ndings of 0.43% and 0.40% per monthly, respectively). the correlations are small in general, except for the correlation be-
The average monthly size premium (SMB) is 0.28% (t = 0.67), tween MP and LIQ1. MP is highly negatively correlated with LIQ1
which is similar to that of the US (0.21% for Keene and Peterson with a coefcient of 0.5345 and a p-value of less than 0.0001.
(2007) and 0.27% for Fama and French (1993)). The average SMB and HML are both negatively correlated with LIQ1 with coef-
monthly momentum premium (WML) is 0.42% (t = 1.23), while cients of 0.1833 (p-value of 0.0022) and 0.1894 (p-value of
Keene and Peterson report a higher and positive premium of 0.91% 0.0016) respectively.
in the US. Unlike the positive premium in the US, the momentum Table 2 shows that the mean returns of the liquidity factors and
effect in Hong Kong tends to be insignicant and close to zero. This the four factors are mostly positive (except WML, LIQ5 and LIQ7).
is consistent with the very weak and insignicant momentum The positive mean returns of liquidity factors suggest that liquidity
coefcients found in Table 5 (to be discussed below) and in other factors are also positively related to certain systematic risk factors
studies (e.g., Chen and Fang, 2009). and that they may not be independent from but positively corre-
lated with the non-liquidity factors. However, Table 3 shows that
Table 2 the correlations between the liquidity factor (LIQ1) and the four
Descriptive statistics of the explanatory variables in the time-series regressions July other factors (MP, SMB, HML, and WML) are either positive but
1981June 2004. Monthly time-series statistics are reported for the factor returns small in magnitude or negative. This may indicate that the liquidity
explanatory monthly stock portfolio returns. MP is the monthly market excess return,
factor is an underlying risk factor in addition to the well-
MP t  MP2 is the squared of the monthly market excess return minus its time-series
average, SMB is the monthly return of a hedging portfolio formed by buying small
documented four factors and it captures another dimension of
stocks and selling large stocks, HML is the monthly return of a hedging portfolio the systematic risk.
formed by buying high BM stocks and selling low BM stocks, WML is the monthly
return of a hedging portfolio formed by buying past winners and selling past losers. 4.2. Regression analysis
The construction of these factors follows those of Fama and French (1992) and Lher
et al. (2004). LIQ1 is the liquidity factor constructed based on turnover ratio. LIQ2
LIQ9 are constructed based on other proxies of stock liquidity. Refer to Appendix A for Table 4 reports regression results for the three-factor model
the exact denitions of those proxies. (MP, SMB, and HML). The size- and liquidity-sorted results, and
the BM- and liquidity-sorted results are reported in Panels A and
Variable Mean Std. dev. t-Value Minimum Maximum
B, respectively. The results based on liquidity sorting only are sim-
MP 1.1919 8.7824 2.25 45.7037 31.3187
ilar and, therefore, are not reported here. In Panel A, 12 of the inter-
MP t  MP2 76.4260 182.3932 6.96 0.0014 2213.3000
cepts are signicantly different from zero at the 5% level. The GRS
SMB 0.2753 6.8210 0.67 21.8056 37.0940
HML 0.8339 4.7164 2.94 12.8231 24.6574 F-tests also indicate that the intercepts are jointly signicantly dif-
WML 0.4231 5.7092 1.23 24.0413 22.2109 ferent from zero at the 1% level. Small and illiquid rms tend to
LIQ1 1.2751 6.4608 3.28 38.2370 28.1653 have positive intercepts, while big and liquid rms tend to have
LIQ2 2.0976 7.2888 4.76 30.6944 27.1043 negative intercepts. This rejects our null hypothesis but suggests
LIQ3 1.2378 6.2303 3.30 37.5865 21.5520
LIQ4 1.8232 6.7940 4.46 29.2942 26.1724
that liquidity is not priced in the Hong Kong stock market. Most
LIQ5 0.0691 4.4216 0.26 24.9155 13.4432 of the MP, SMB, and HML factor coefcients are signicant. The
LIQ6 0.0467 4.7031 0.17 19.4234 19.8990 average MP coefcient is close to 1.0, which is consistent with
LIQ7 0.0319 3.8926 0.14 17.1110 20.0589 Keene and Peterson (2007) and Fama and French (1993). The
LIQ8 1.4878 7.1607 3.41 23.4793 31.0714
coefcient of SMB decreases as size increases, whereas it increases
LIQ9 0.4284 6.5755 1.08 28.2435 28.4618
as liquidity increases.
2222 K.S.K. Lam, L.H.K. Tam / Journal of Banking & Finance 35 (2011) 22172230

Table 3
Correlations of the factor monthly returns July 1981June 2004. Pearson pair-wise correlations for the monthly time-series factor returns and the corresponding p-value are
reported. Panel A reports pair-wise correlations for the liquidity factors (LIQ1LIQ9) and Panel B reports pair-wise correlations for non-liquidity factors and the liquidity factor
constructed based on turnover ratio (LIQ1). All variables are dened in Table 2 and Appendix A.

LIQ1 LIQ2 LIQ3 LIQ4 LIQ5 LIQ6 LIQ7 LIQ8 LIQ9

Panel A (Correlations for the liquidity factors)
LIQ1 1.0000
LIQ2 0.7830 1.0000
<0.0001
LIQ3 0.9539 0.6940 1.0000
<0.0001 <0.0001
LIQ4 0.8372 0.9014 0.7763 1.0000
<0.0001 <0.0001 <0.0001
LIQ5 0.0312 0.2694 0.2167 0.1337 1.0000
0.6064 <0.0001 0.0003 0.0263
LIQ6 0.3181 0.0024 0.4855 0.1512 0.8687 1.0000
<0.0001 0.9679 <0.0001 0.0119 <0.0001
LIQ7 0.0612 0.0250 0.0202 0.0739 0.0405 0.0245 1.0000
0.3108 0.6799 0.7384 0.2208 0.5028 0.6854
LIQ8 0.4607 0.7191 0.3155 0.6080 0.5541 0.3626 0.0215 1.0000
<0.0001 <0.0001 <0.0001 <0.0001 <0.0001 <0.0001 0.7248
LIQ9 0.6822 0.7583 0.5578 0.7504 0.4308 0.2023 0.0738 0.7264 1.0000
<0.0001 <0.0001 <0.0001 <0.0001 <0.0001 0.0007 0.2217 <0.0001
MP MPt  MP2 SMB HML WML LIQ1

Panel B (Correlations for the four non-liquidity factors and LIQ1)

MP 1.0000
MP t  MP2 0.1880 1.0000
0.0017
SMB 0.1254 0.1173 1.0000
0.0374 0.0515
HML 0.2455 0.1185 0.0014 1.0000
<0.0001 0.0492 0.9812
WML 0.0703 0.0777 0.0477 0.2551 1.0000
0.2446 0.1981 0.4305 <0.0001
LIQ1 0.5345 0.1321 0.1833 0.1894 0.0728 1.0000
<0.0001 0.0283 0.0022 0.0016 0.2283

If the portfolios are sorted by BM and liquidity, we nd similar
results. In Panel B, 11 of the intercepts are signicantly different
from zero at the 5% level, and the GRS F-test statistics are also sig-
nicant at the 1% level. Again, illiquid rms tend to have positive
intercepts while liquid rms tend to have negative intercepts. This
suggests liquidity is priced. All MP coefcients are signicant, with
an average value close to 1.0. As expected, the coefcient on HML
increases as BM increases. The coefcient of SMB generally in-
creases as liquidity increases, except for rms with the highest
BM. The general trend of SMB coefcients is consistent with that
in Panel A and that found in the US (Keene and Peterson, 2007). Li-
quid, high-BM rms generally have a higher coefcient on HML
than illiquid, low BM rms.
Most of the adjusted R2s fall in the range of 0.500.89 with just
one low R2 at 0.38 in the individual regressions. The R2s are rela-
tively lower than those found in Fama and French (1993), however,
which consistently fall between 95% and 97%. The reason for these
relatively lower R2s is because we sort the stocks differently (by
size and liquidity, or BM and liquidity) than Fama and French do.
The low R2s also indicate that FamaFrench factors are less appli-
cable to the Hong Kong stock market.
From Table 4, we nd that all three factors (MP, SMB, and HML)
work well in Hong Kong. In an unreported robustness check, we
also perform the augmented four-factor model test by including
WML (momentum) as the fourth factor. The results are similar to
those of the three-factor model, with WML coefcients mostly
insignicant. Using different liquidity portfolios, we nd that the
numbers of signicant WML coefcients range from 2 to 12, with
most falling in the range of 610.10 The results indicate that three
10
The results are available upon request.
factors (MP, SMB, and HML) are priced by Hong Kong stocks, while
the momentum factor (WML) is not. However, the large number of
signicant intercepts on Table 4 suggests that there may be miss-
ing factors that cannot be captured by the three-factor model. This
calls for additional factors to control for the remaining effects.
In Table 5, we report the regression results on the ve factors of
MP, SMB, HML, WML and LIQ (Eq. (4)). Panel A reports the results on
size- and liquidity-sorted portfolios, while panel B reports those on
BM- and liquidity-sorted. Similar to the results of the three-factor
model (Table 4), small rms tend to have positive intercepts, while
big rms tend to have negative intercepts (Panel A). Only 6 inter-
cepts, however, are signicantly different from zero at the 5% level,
compared to 12 signicant intercepts in Table 5. Although the GRS
F-test still shows that the intercepts are jointly signicantly differ-
ent from zero, we observe a signicant reduction in the F-statistics
from the three-factor model (4.70) to the liquidity ve-factor mod-
el (3.03). We observe a similar pattern when we use alterative
liquidity measures to construct size-liquidity portfolios.
Most of the intercepts for BM- and liquidity-sorted rms are
statistically insignicant with no obvious difference between
low-BM and high-BM rms (Panel B). This pattern is different from
that of the three-factor model (Table 4). Only one intercept is sig-
nicant at the 5% level, compared to 11 in Table 4. The GRS F-test
does not reject the null hypothesis that the intercepts are jointly
equal to zero.
Table 5 also shows that most of the factor coefcients are signif-
icant, with MP being the strongest. All of the MP coefcients are
signicant, while at least 17 of the coefcients of SMB, HML, and
LIQ are signicant at the 5% level. As documented in most previous
studies, the average MP coefcient is close to 1.0, the coefcient of
SMB decreases as size increases (Panel A), and the coefcient on
HML increases as BM increases (Panel B). The LIQ coefcients tend
 K.S.K. Lam, L.H.K. Tam / Journal of Banking & Finance 35 (2011) 22172230 2223

Table 4
Results from the FamaFrench three-factor regressions for the monthly returns of the 25 size-liquidity portfolios and BM-liquidity portfolios July 1981 to June 2004.
rp,t  rf,t = ai + bpMPt + spSMBt + hpHMLt + ep,t. The table reports the coefcients with the corresponding t-statistics from the FamaFrench three-factor regressions for the monthly
returns of the 25 size-liquidity portfolios (Panel A) and BM-liquidity portfolios (Panel B). The GRS F-test for the null hypothesis that the 25 coefcients of the intercept terms are
jointly equal to zero and the corresponding p-value are reported at the bottom of each panel.

Liquidity quintile Size quintile

a t(a)
1 2 3 4 5 1 2 3 4 5
Panel A
1 1.958 0.489 0.477 0.433 0.234 4.23 1.44 1.41 1.33 0.60
2 1.412 0.729 0.432 0.304 0.367 2.80 1.70 1.39 0.85 1.37
3 1.510 0.353 1.077 1.015 0.294 2.39 0.88 3.06 3.15 1.47
4 0.457 0.074 1.186 1.993 0.996 0.65 0.13 2.71 6.02 3.34
5 0.132 1.202 2.843 2.106 1.233 0.21 2.17 6.80 4.22 2.69
b t(b)
1 0.740 0.609 0.701 0.655 0.750 13.70 15.44 17.79 17.36 16.54
2 0.912 1.002 0.833 0.919 0.970 15.54 20.01 23.00 22.08 31.07
3 0.946 0.941 1.064 1.019 1.021 12.89 20.14 26.02 27.37 43.95
4 0.980 1.093 1.139 1.089 1.154 11.97 16.56 22.53 28.33 33.35
5 1.319 1.100 1.209 1.323 1.233 18.13 17.10 24.90 22.84 23.39
s t(s)
1 0.987 0.568 0.332 0.239 0.044 14.61 11.53 6.74 5.07 0.78
2 1.081 0.860 0.477 0.267 0.140 14.74 13.86 10.56 5.14 3.59
3 1.380 0.836 0.768 0.284 0.113 15.11 14.49 15.04 6.11 3.90
4 1.121 1.031 0.783 0.435 0.015 11.04 12.52 12.37 9.06 0.36
5 1.273 1.053 0.709 0.408 0.084 14.01 13.12 11.70 5.65 1.28
h t(h)
1 0.296 0.371 0.246 0.393 0.097 2.87 5.09 3.39 5.63 1.17
2 0.038 0.119 0.281 0.130 0.223 0.35 1.30 4.19 1.69 3.86
3 0.103 0.332 0.488 0.473 0.117 0.76 3.88 6.46 6.70 2.72
4 0.872 0.229 0.204 0.272 0.430 5.63 1.88 2.17 3.82 6.72
5 0.422 0.313 0.502 0.261 0.364 3.14 2.63 5.59 2.44 3.78
R2
1 0.61 0.60 0.60 0.60 0.53
2 0.62 0.68 0.72 0.67 0.81
3 0.58 0.71 0.78 0.78 0.89
4 0.55 0.61 0.71 0.78 0.83
5 0.66 0.63 0.76 0.69 0.71

BM quintile
a t(a)
Panel B
1 0.327 0.860 0.658 0.995 0.470 0.74 1.87 1.97 2.41 0.98
2 0.193 0.805 0.221 0.282 0.405 0.54 2.19 0.69 0.72 0.97
3 0.368 0.518 0.132 0.740 0.226 1.02 1.78 0.33 2.21 0.53
4 1.505 1.108 0.599 0.030 0.884 2.77 3.15 1.47 0.07 1.86
5 2.239 2.092 1.482 1.060 1.343 4.61 4.06 2.60 2.01 2.51
b t(b)
1 0.637 0.780 0.736 0.598 0.807 11.48 14.63 19.00 12.49 14.47
2 0.928 0.908 0.972 0.946 1.004 22.39 21.24 25.91 20.84 20.75
3 0.926 0.824 1.053 1.050 1.005 22.11 27.40 22.76 26.96 20.37
4 1.011 1.135 1.100 1.086 1.117 16.01 27.80 23.30 20.92 20.28
5 1.174 1.234 1.282 1.260 1.200 20.82 20.63 19.34 20.56 19.33
s t(s)
1 0.210 0.493 0.443 0.641 0.726 3.29 7.41 9.16 10.72 10.43
2 0.322 0.463 0.463 0.515 0.750 6.23 8.67 9.89 9.08 12.42
3 0.431 0.341 0.596 0.588 0.579 8.24 8.10 10.33 12.10 9.40
4 0.526 0.507 0.693 0.733 0.751 6.67 9.96 11.77 11.30 10.92
5 0.786 0.795 0.733 0.718 0.645 11.16 10.65 8.86 9.39 8.23
h t(h)
1 0.076 0.134 0.232 0.401 0.703 0.81 1.36 3.24 4.54 6.82
2 0.125 0.008 0.066 0.224 0.686 1.63 0.10 0.95 2.67 7.67
3 0.138 0.183 0.202 0.470 0.810 1.79 2.93 2.36 6.53 8.89
4 0.400 0.240 0.381 0.657 0.794 3.43 3.19 4.37 6.85 7.87
5 0.150 0.271 0.395 0.687 0.843 1.44 2.45 3.22 6.07 7.35
R2
1 0.38 0.51 0.64 0.53 0.60
2 0.66 0.65 0.74 0.67 0.73

(continued on next page)

2224 K.S.K. Lam, L.H.K. Tam / Journal of Banking & Finance 35 (2011) 22172230
Table 4 (continued)
Liquidity quintile Size quintile
a t(a)
1 2 3 4
3 0.66 0.76 0.70
4 0.51 0.77 0.73
5 0.66 0.67 0.64
GRS test statistics: 4.70; p-value: <0.01 (Panel A).
GRS test statistics: 2.39; p-value: <0.01 (Panel B).
to be positive for small rms and negative for big rms, and posi-
tive for illiquid rms and negative for liquid rms. Only a few coef-
cients of WML are statistically signicant at the 5% level. The
results show that the WML factor does not play a signicant role
in pricing Hong Kong stocks. In an unreported robustness check,
we estimate the Eq. (3) (the model with MP, SMB, HML and LIQ
as factors) and nd that the factor coefcients are very close to
those reported on Table 5. This suggests that a liquidity four-factor
(MKT, SMB, HML, and LIQ) model works well enough in the Hong
Kong stock market. Finally, the adjusted R2s of the ve-factor
regressions mostly range from 0.50 to 0.90 in individual regres-
sions, except one with a very few low R2s (<0.40). The results on
Tables 4 and 5 indicate that adding two more factors (WML and
LIQ) to the three-factor model have impacts on the three-factor
coefcients. For the three-factor model (Table 4), the market beta
coefcients increase down the columns but remain at across
rows. However, the variations on the beta coefcients are narrower
for the ve-factor model (Table 5). For example, the beta coef-
cients of the smallest rms range from 0.740 to 1.319 for the
three-factor model while those for the ve-factor model range
from 0.918 to 1.126. We observe a similar pattern for the SMB
and HML coefcients. After adding two more factors, the SMB
coefcients become more positive for the least liquid stocks and
less positive for the most liquid stocks. The impacts of the two
factors on the HML coefcients are similar but less dramatic.
Despites these differences, the signicance of the factor coef-
cients remains quite stable even after we add two more factors into
the three-factor model.
Overall, Table 5 suggests that it is important to include a liquid-
ity factor in asset pricing models for Hong Kong. After adding a
liquidity factor to the three-factor model, the number of signicant
intercepts is reduced, as are the GRS F-test statistics.
We also re-run the ve-factor (FamaFrench three factors,
momentum factor, and liquidity factor) models by dividing the
sample period into two: (1) before April 1986 when the four ex-
changes were not merged, and (2) in and after April 1986 when
the four exchanges are unied. Consistent with our results for
the whole sample period, liquid stocks have negative liquidity fac-
tor loadings and illiquidity stocks have positive liquidity factor
loadings in both sub-periods after controlling for size or BM. How-
ever, the number of signicant intercepts (at the 5% level) in the
second sub-period (6/3) is larger than that in the rst sub-period
(2/0) when size-liquidity/BM-liquidity portfolios are used. This
suggests the ve-factor model is a better model for the rst sub-
period than for the second sub-period.
Table 6 reports the trends of the intercepts for various models.
Panels A and B report the results sorted by size and book-to-
market ratio, respectively. Both panels show that there is a consis-
tent pattern in the intercepts for three-moment and three-factor
models. The intercepts decrease from the lowest-liquidity portfolio
to the highest-liquidity portfolio. When liquidity is included as a
factor into the model (liquidity four-factor and ve-factor models),
however, the decreasing trend in the intercepts vanishes. Most of
the intercepts for the two models do not exhibit any trend, except
the middle-size (Panel A) and largest BM (Panel B) portfolios. This
5 1 2 3 4 5
0.78 0.71
0.71 0.71
0.69 0.67
nding suggests that liquidity is not related to size and book-
to-market ratio and that liquidity is an independent factor which
explains stock returns in the Hong Kong market.
With the favorable results in Tables 5 and 6 on the intercepts
and coefcients of the risk factors, the liquidity four-factor model
(MKT, SMB, HML, and LIQ) seems to work well in the Hong Kong
stock market.11
4.3. Comparison of three- and ve-factor (or four-factor) models
To investigate further whether the liquidity ve-factor (or four-
factor) model is better than the three-factor model, we check the
improvement in the number of insignicant intercepts and the
percentage increase in the adjusted R2s of the two models. If one
model is better than the other, we expect to see an increase in
the number of insignicant intercepts and adjusted R2s.
The number of insignicant intercepts is substantially greater
for the liquidity ve-factor (or four-factor) model than for the
three-factor model. For example, compare the Panel B of Table 4
with the Panel B of Table 5. The number of insignicant intercepts
increases from 14 (three-factor) to 24 (ve-factor). This represents
an overall increase of 71% for the insignicant intercepts when the
liquidity ve-factor (or four-factor) model is used instead of the
three-factor model. The adjusted R2s also increase by an average
of 4% across the board if we switch from the three-factor model
to the liquidity ve-factor (or four-factor) model.
The substantial increase in insignicant intercepts, together
with the modest increases in adjusted R2s, shows that the liquidity
ve-factor (or four-factor) model signicantly improves the expla-
nation power on the excess expected stock returns over the three-
factor model. Therefore, the results suggest that using the liquidity
ve-factor (or four-factor) model (MKT, SMB, HML, LIQ and/or
MOM) as the benchmark model is a more appropriate choice than
using the three-factor or momentum four-factor (MKT, SMB, HML,
and MOM) models.
4.4. Robustness tests
To further check the validity of the liquidity ve-factor (or four-
factor) model, we conduct the following three robustness tests: a
possible additional factor check (using portfolio residuals and
higher moment coskewness factor), a seasonality check (on
months, especially on January vs. non-January months), and a con-
ditional market check (on up- and down-markets).12
11
In a robustness check, we calculate value-weighted returns, instead of equally-
weighted returns, of those 25 testing portfolios and our main ndings in Tables 46
generally hold. However, our results show that using value-weighted portfolio
returns results in a larger number of negative coefcients and the intercepts generally
are more negative in for the largest rms. A possible explanation for this is that we
put more weights on large stocks in calculating value-weighted returns than in
calculating equally-weighted returns. As large stocks are found to underperform
small stocks, the use of value-weighted returns will result in more negative
coefcients if SMB cannot fully capture cross-sectional variations in returns between
small and big stocks.
12
To save space, results are not reported but are available upon request.
 K.S.K. Lam, L.H.K. Tam / Journal of Banking & Finance 35 (2011) 22172230 2225

Table 5
Results from the ve-factor (FamaFrench three factors plus momentum factor and liquidity factor) regressions for the monthly returns of the 25 size-liquidity portfolios and BM-
liquidity portfolios July 1981June 2004. rp,t  rf,t = ap + pMPt + spSMBt + hpHMLt + wpWML + pLIQt + p,t. The table reports the coefcients with the t-statistics from the ve-factor
(FamaFrench three factors plus liquidity factor and momentum factor) regressions for the monthly returns of the 25 size-liquidity portfolios (Panel A) and BM-liquidity
portfolios (Panel B). The GRS F-test for the null hypothesis that the 25 coefcients of the intercept terms are jointly equal to zero and the corresponding p-value are reported at the
bottom of each panel.

Liquidity quintile Size quintile

a t(a)
1 2 3 4 5 1 2 3 4 5
Panel A
1 1.193 0.515 0.265 0.654 0.425 2.56 1.67 0.79 1.91 1.03
2 0.766 0.589 0.443 0.485 0.403 1.45 1.29 1.35 1.28 1.41
3 0.634 0.487 0.801 0.521 0.088 0.97 1.15 2.18 1.58 0.44
4 1.599 0.799 0.156 1.262 0.363 2.25 1.37 0.37 3.88 1.24
5 1.287 0.435 1.497 0.306 0.025 2.10 0.85 4.02 0.74 0.06
b t(b)
1 0.918 0.821 0.858 0.708 0.790 14.75 20.24 19.48 15.69 14.42
2 1.044 1.029 0.841 0.882 0.975 15.07 17.12 19.38 17.63 25.92
3 1.126 0.971 1.010 0.912 0.939 13.12 17.34 2.84 20.87 35.34
4 0.702 0.905 0.922 0.934 1.022 7.44 11.74 16.81 21.74 26.59
5 1.002 0.740 0.916 0.939 0.992 12.40 11.00 18.65 17.12 18.61
s t(s)
1 1.096 0.688 0.422 0.274 0.067 16.19 15.58 8.80 5.57 1.12
2 1.164 0.873 0.487 0.248 0.140 15.26 13.38 10.29 4.54 3.41
3 1.480 0.860 0.741 0.222 0.161 15.87 14.17 14.02 4.70 4.56
4 0.952 0.920 0.655 0.345 0.058 9.37 10.96 10.89 7.37 1.39
5 1.077 0.835 0.535 0.185 0.048 12.23 11.40 9.99 3.10 0.83
h t(h)
1 0.382 0.373 0.259 0.437 0.095 3.78 5.80 3.70 6.10 1.09
2 0.059 0.102 0.322 0.141 0.202 0.54 1.07 4.67 1.78 3.38
3 0.086 0.370 0.521 0.459 0.104 0.63 4.17 6.76 6.47 2.46
4 0.687 0.197 0.212 0.258 0.440 4.47 1.61 2.43 3.78 7.20
5 0.282 0.197 0.434 0.217 0.410 2.19 1.84 5.55 2.49 4.89
w t(w)
1 0.161 0.119 0.053 0.115 0.032 1.98 2.27 0.93 1.97 0.46
2 0.010 0.745 0.131 0.060 0.072 0.11 0.96 2.34 0.93 1.49
3 0.164 0.103 0.140 0.046 0.008 1.48 1.43 2.24 0.81 0.22
4 0.328 0.006 0.186 0.048 0.113 2.72 0.06 2.61 0.87 2.29
5 0.273 0.167 0.048 0.083 0.312 2.62 1.93 0.75 1.18 4.53
w t(w)
1 0.439 0.523 0.389 0.126 0.100 5.16 9.43 6.45 2.04 1.34
2 0.328 0.068 0.016 0.091 0.014 3.45 0.83 0.27 1.33 0.26
3 0.444 0.082 0.135 0.263 0.202 3.79 1.07 2.03 4.37 5.55
4 0.674 0.462 0.540 0.384 0.327 5.17 4.38 7.45 6.63 6.21
5 0.773 0.880 0.717 0.947 0.618 6.99 9.57 10.68 12.63 8.54
R2
1 0.64 0.71 0.65 0.61 0.53
2 0.63 0.68 0.72 0.67 0.81
3 0.60 0.71 0.79 0.80 0.90
4 0.59 0.64 0.77 0.81 0.86
5 0.71 0.72 0.83 0.81 0.80
BM quintile
a t(a)
Panel B
1 0.153 0.276 0.150 0.104 0.733 0.33 0.58 0.44 0.27 1.61
2 0.172 0.927 0.076 0.014 0.059 0.46 2.38 0.22 0.03 0.13
3 0.164 0.532 0.038 0.569 0.394 0.43 1.72 0.09 1.60 0.89
4 0.416 0.173 0.008 0.496 0.317 0.77 0.51 0.02 1.06 0.69
5 0.828 0.894 0.016 0.588 0.620 1.88 1.77 0.03 1.24 1.40
b t(b)
1 0.738 0.903 0.847 0.837 1.058 12.18 14.37 18.73 16.20 17.66
2 1.007 0.887 1.003 1.000 1.077 20.39 17.30 22.16 18.41 18.60
3 0.879 0.926 1.034 1.015 0.972 17.45 22.70 18.49 21.68 16.36
4 0.783 0.938 0.969 0.974 0.857 11.02 21.52 17.53 15.83 14.24
5 0.877 0.975 0.960 0.904 0.780 15.05 14.65 13.40 14.29 13.38
s t(s)
1 0.268 0.574 0.511 0.783 0.867 4.05 8.30 10.35 13.91 13.28
2 0.369 0.455 0.482 0.543 0.791 6.86 8.14 9.76 9.16 12.54

(continued on next page)

2226 K.S.K. Lam, L.H.K. Tam / Journal of Banking & Finance 35 (2011) 22172230

Table 5 (continued)

Liquidity quintile Size quintile

a t(a)
1 2 3 4 5 1 2 3 4 5
3 0.401 0.341 0.586 0.569 0.563 7.30 7.67 9.62 11.16 8.69
4 0.398 0.395 0.616 0.668 0.597 5.14 8.31 10.22 9.96 9.10
5 0.617 0.641 0.545 0.508 0.400 9.72 8.84 6.97 7.43 6.30
h t(h)
1 0.069 0.181 0.269 0.459 0.693 0.72 1.82 3.74 5.58 7.28
2 0.107 0.026 0.071 0.203 0.686 1.36 0.32 0.99 2.35 7.46
3 0.167 0.172 0.207 0.480 0.829 2.09 2.66 2.33 6.45 8.78
4 0.390 0.234 0.353 0.646 0.740 3.46 3.37 4.02 6.61 7.74
5 0.152 0.213 0.346 0.618 0.786 1.64 2.02 3.04 6.19 8.49
w t(w)
1 0.039 0.079 0.056 0.045 0.179 0.50 0.97 0.96 0.67 2.32
2 0.011 0.127 0.001 0.101 0.041 0.17 1.91 0.02 1.44 0.55
3 0.068 0.035 0.028 0.056 0.083 1.04 0.67 0.39 0.92 1.09
4 0.169 0.096 0.013 0.029 0.022 1.84 1.71 0.18 0.37 0.28
5 0.171 0.035 0.032 0.015 0.064 2.27 0.41 0.34 0.18 0.85
w t(w)
1 0.250 0.305 0.274 0.586 0.622 3.01 3.53 4.42 8.30 7.60
2 0.194 0.055 0.077 0.135 0.180 2.88 0.78 1.25 1.81 2.28
3 0.113 0.005 0.047 0.086 0.083 1.64 0.09 0.62 1.34 1.01
4 0.564 0.488 0.323 0.276 0.638 5.80 8.19 4.27 3.28 7.75
5 0.734 0.637 0.791 0.875 1.035 9.21 7.00 8.07 10.18 12.98
R2
1 0.40 0.53 0.66 0.62 0.68
2 0.67 0.66 0.74 0.67 0.73
3 0.67 0.76 0.70 0.79 0.71
4 0.57 0.82 0.75 0.72 0.76
5 0.75 0.72 0.71 0.78 0.80

GRS test statistics: 3.03; p-value: <0.01 (Panel A).

GRS test statistics: 1.01; p-value: 0.45 (Panel B).

The rst robustness test is to determine the explanatory power
on possible additional factor(s) besides the four factors we found in
this paper. If some factors are missing in the model, they will show
up in the residuals of regression. Therefore, we test a factor model
by adding the standard deviation of the portfolio residuals into the
liquidity factor model. We nd that the residual coefcients are
mostly insignicant and that the results of the other factors and
intercepts are similar to the results in Table 5.13 The results suggest
that the residual standard deviation has no statistical impact on the
liquidity factor model. Therefore, the four factors, MP, SMB, HML, and
LIQ, seem to capture most of the common variation of portfolio
returns.
Kraus and Litzenberger (1976) show that conditional skewness
and higher-order comoments help explain the cross-sectional
variation of stock returns. To answer the question whether
coskewness risk captures liquidity, we conduct a robustness test
by including the higher moment factor, coskewess MPt  MP2 ,
into our liquidity factor model:
Rpt  Rft ap bp MP t sp SMBt hp HMLt wp LIQ t
up MP t  MP2 ept
We nd that the intercepts remain mostly insignicant and that the
factor coefcients are largely consistent with those reported in Ta-
ble 5. The coefcients of the higher moment factor are mostly insig-
nicant, however.
We next check the seasonality effect on the liquidity factor
model. We perform a regression on Eqs. (3) and (4) by months.
13
We also perform robustness tests on the ve-factor model (Eq. (4)) on additional
factor, seasonality and conditional markets and nd similar results as Table 5. To save
space, results are not reported but are available upon request.
We nd some slight changes on the coefcients, but the general
pattern remains the same as in Table 5. We do not nd any irreg-
ular patterns across months or in any particular month. To check
whether the results are affected by January, we also perform
regressions on Eqs. (3) and (4) by January and non-January months.
Again, the results in January and non-January months are quite
similar and consistent with the monthly regression results and
the results in Table 5. In general, we nd no obvious seasonal pat-
terns in the seasonality tests. The results suggest that the liquidity
factor model is not affected by a seasonal factor and is robust to the
seasonal effect.
We then check the robustness of the liquidity factor model on
up- and down-market conditions. Pettengill et al. (1995) argue that
up- and down-market conditions should be considered and that
the relation between realized returns and beta is conditional on
the relation between realized market returns and the risk-free rate.
In Hong Kong, Lam (2001) shows that there is a strong relation be-
tween beta and return in both up- and down-markets. Therefore,
we conduct an analysis of our model on up- and down-markets.
Following Pettengill et al. (1995) and Lam (2001), the market is
5 classied as an up-market (down-market) if the realized market
excess return is positive (negative). The sample period is then split
into up- and down-market periods and Eqs. (3) and (4) are run
independently on up- and down-markets. Consistent with our re-
sults for the whole sample period, liquid stocks have negative
liquidity factor loadings and illiquidity stocks have positive liquid-
ity factor loadings in both sub-periods after controlling for size or
BM. In addition, the number of signicant intercepts (at the 5% le-
vel) in down-markets (3/2) is about the same as that in up-markets
(1/2) when size-liquidity/BM-liquidity portfolios are used. This
suggests that the liquidity factor model is a good model for both
up-markets and for down-markets.
 K.S.K. Lam, L.H.K. Tam / Journal of Banking & Finance 35 (2011) 22172230 2227

Table 6
Comparison of the intercepts from alternative factor models for monthly returns of the 25 size-liquidity portfolios and BM-liquidity portfolios July 1981June 2004. The table
reports the intercept coefcients with the corresponding t-statistics from alternative factor model regressions for the monthly returns of the 25 size-liquidity portfolios (Panel A)
and BM-liquidity portfolios (Panel B). Besides, within each size or BM quintile, a hedging portfolio is formed between the most liquid stock (liquidity quintile 5) and the least
liquid stock (liquidity quintile 1) and its monthly return is regressed on the factors. The intercept coefcient and t-test statistics from factor model regression is reported on the
row (5)  (1).

Liquidity quintile Size quintile

a t(a)
1 2 3 4 5 1 2 3 4 5
Panel A
3-moment
1 2.268 1.120 1.206 0.290 0.406 3.32 2.42 3.02 0.76 0.98
2 2.289 1.197 0.302 0.714 0.154 3.13 1.97 0.74 1.76 0.51
3 1.895 1.127 0.095 0.630 0.202 2.04 1.97 0.18 1.58 0.90
4 1.154 1.156 0.290 1.296 0.713 1.19 1.50 0.49 3.12 2.05
5 1.240 0.183 1.930 2.002 0.867 1.38 0.24 3.35 3.48 1.70
(5)  (1) 1.101 1.303 3.136 2.292 1.388 1.43 1.57 5.25 3.90 2.18

3-factor
1 1.958 0.489 0.477 0.433 0.234 4.23 1.44 1.41 1.33 0.60
2 1.412 0.729 0.432 0.304 0.367 2.80 1.70 1.39 0.85 1.37
3 1.510 0.353 1.077 1.015 0.294 2.39 0.88 3.06 3.15 1.47
4 0.457 0.074 1.186 1.993 0.996 0.65 0.13 2.71 6.02 3.34
5 0.132 1.202 2.843 2.106 1.233 0.21 2.17 6.80 4.22 2.69
(5)  (1) 2.046 1.691 3.326 1.673 1.105 2.80 2.56 6.68 3.33 2.02

3-factor plus liquidity

1 1.222 0.539 0.276 0.630 0.431 2.61 1.74 0.83 1.83 1.04
2 0.764 0.575 0.416 0.497 0.418 1.45 1.27 1.26 1.31 1.47
3 0.604 0.467 0.772 0.514 0.090 0.92 1.10 2.09 1.56 0.45
4 1.559 0.800 0.122 1.252 0.339 2.16 1.37 0.29 3.85 1.15
5 1.231 0.401 1.507 0.289 0.045 1.99 0.78 4.05 0.69 0.11
(5)  (1) 0.081 0.940 1.237 0.342 0.381 0.10 1.67 2.97 0.68 0.65

4-factor plus liquidity

1 1.193 0.515 0.265 0.654 0.425 2.56 1.67 0.79 1.91 1.03
2 0.766 0.589 0.443 0.485 0.403 1.45 1.29 1.35 1.28 1.41
3 0.634 0.487 0.801 0.521 0.088 0.97 1.15 2.18 1.58 0.44
4 1.599 0.799 0.156 1.262 0.363 2.25 1.37 0.37 3.88 1.24
5 1.287 0.435 1.497 0.306 0.025 2.10 0.85 4.02 0.74 0.06
(5)  (1) 0.001 0.950 1.238 0.348 0.312 0.00 1.66 2.98 0.69 0.55

BM quintile
a t(a)
Panel B
3-moment
1 0.867 1.385 1.096 1.451 1.020 1.81 2.54 2.62 2.65 1.56
2 0.258 1.218 1.070 0.922 1.007 0.62 2.72 2.69 1.90 1.67
3 0.084 0.165 0.310 0.086 1.194 0.19 0.47 0.61 0.18 2.04
4 0.909 0.516 0.508 0.913 0.220 1.43 1.15 0.93 1.47 0.33
5 1.396 1.318 1.039 0.219 0.272 2.22 1.97 1.46 0.32 0.39
(5)  (1) 2.294 2.738 2.135 1.680 1.258 3.13 3.94 3.14 2.23 1.51

3-factor
1 0.327 0.860 0.658 0.995 0.470 0.74 1.87 1.97 2.41 0.98
2 0.193 0.805 0.221 0.282 0.405 0.54 2.19 0.69 0.72 0.97
3 0.368 0.518 0.132 0.740 0.226 1.02 1.78 0.33 2.21 0.53
4 1.505 1.108 0.599 0.030 0.884 2.77 3.15 1.47 0.07 1.86
5 2.239 2.092 1.482 1.060 1.343 4.61 4.06 2.60 2.01 2.51
(5)  (1) 2.575 3.045 2.141 2.050 1.771 3.98 4.87 3.60 3.34 2.50

3-factor plus liquidity

1 0.162 0.297 0.162 0.094 0.772 0.35 0.62 0.47 0.24 1.69
2 0.170 0.953 0.075 0.007 0.050 0.46 2.44 0.22 0.02 0.12
3 0.178 0.540 0.032 0.558 0.411 0.47 1.75 0.08 1.57 0.91
4 0.381 0.154 0.005 0.502 0.312 0.70 0.46 0.01 1.08 0.69
5 0.793 0.901 0.022 0.585 0.633 1.78 1.57 0.04 1.23 1.43
(5)  (1) 0.633 1.285 0.140 0.684 1.463 0.99 1.91 0.24 1.39 2.83

(continued on next page)

2228 K.S.K. Lam, L.H.K. Tam / Journal of Banking & Finance 35 (2011) 22172230

Table 6 (continued)

Liquidity quintile Size quintile

a t(a)
1 2 3 4 5 1 2 3 4 5
4-factor plus liquidity
1 0.153 0.276 0.150 0.104 0.733 0.33 0.58 0.44 0.27 1.61
2 0.172 0.927 0.076 0.014 0.059 0.46 2.38 0.22 0.03 0.13
3 0.164 0.532 0.038 0.569 0.394 0.43 1.72 0.09 1.60 0.89
4 0.416 0.173 0.008 0.496 0.317 0.77 0.51 0.02 1.06 0.69
5 0.828 0.894 0.016 0.588 0.620 1.88 1.77 0.03 1.24 1.40
(5)  (1) 0.681 1.256 0.135 0.696 1.411 1.07 1.87 0.23 1.41 2.77

The above three robustness tests show that the favorable liquid-
ity factor model test results are driven by neither seasonality nor
up- and down-market conditions. In addition, no extra important
factors are found to price the cross-sectional stock returns beyond
the four factors, MP, SMB, HML and LIQ, in the Hong Kong stock
market.
Finally, we also check if our results are robust to the alternative
denitions of liquidity factors. We have re-run the regressions for
25 size-liquidity portfolio returns using liquidity factors con-
structed by other liquidity measures. In general, liquidity factors
given by turnover ratio (LIQ1), trading volume (LIQ2), the standard
deviation of turnover ratio (LIQ3) and the standard deviation of
trading volume (LIQ4) produce the best and most consistent results
(with liquidity factor loadings high for illiquid stocks and low for
liquid stock, and low numbers of signicant intercepts (5 to 7)).
Liquidity factors given by the CV of turnover (LIQ5), the CV of trad-
ing volume (LIQ6) and Pastor and Stambaughs (2003) measure
(LIQ7) produce the worst and inconsistent results (no observable
pattern in liquidity factor loadings, and high numbers of signicant
intercepts (12)). Liquidity factors given by Amihuds (2002) mea-
sure (LIQ8) and Lius (2006) measure (LIQ9) produce the pattern
of factor loadings consistent with our expectation but the numbers
of signicant intercepts are still high (10 to 11). The nding is con-
sistent with Table 2 that the liquidity factors LIQ5, LIQ6 and LIQ7
are associated very low factor premiums and Table 3 that they
are mostly insignicantly or negatively related to other liquidity
factors. This is also consistent with Keene and Peterson (2007)
who nd that the results for the CV of dollar volume and the CV
of turnover are generally insignicant.
5. Conclusions
the three-moment CAPM, the FamaFrench three-factor model,
and the augmented FamaFrench factor model.
Our results show that liquidity is an important factor pricing re-
turns in Hong Kong after taking well-documented asset pricing fac-
tors into consideration. We also check the robustness of liquidity
by investigating portfolio residuals and higher moment coskew-
ness for possible missing factors, seasonality for seasonal impact,
and up- and down-market for a conditional market effect. We also
perform multivariate regressions on all related factors and nd
that the best model, among all asset pricing models, is a liquidity
four-factor model that includes market excess return, size, book-
to-market ratio, and the liquidity factor. On the other hand, the
momentum factor is not priced in the Hong Kong stock market.
Acknowledgments
The authors would like to thank Ike Mathur, the Managing Edi-
tor, and an anonymous referee for their enlightening and helpful
comments. Keith Lam and Lewis Tam also gratefully acknowledge
the nancial support from the researching funding by the
University of Macau. All remaining errors are ours.
Appendix A. Nine liquidity proxies
We construct nine liquidity proxies: turnover ratio (Datar et al.,
1998; Chan and Faff, 2005), trading volume (Brennan et al., 1998),
standard deviation and coefcient of variation of turnover ratio
and trading volume (Chordia et al., 2001), Pastor and Stambaugh
(2003) liquidity ratio, Amihud (2002) illiquidity ratio, and Liu
(2006) liquidity ratio. The liquidity proxies are calculated for each
July from 1981 to 2003 and they are dened as follows:

In this paper, we address the importance of liquidity in pricing
returns in the context of known time-series determinants in Hong
Kong. Previous studies do not adequately address the relations
among liquidity, traditional important asset pricing factors, and
stock returns in the Hong Kong and Asian stock markets. We hope
that studying a highly volatile market such as Hong Kong
provides better and more robust results on the return-liquidity
(illiquidity) relation and helps shed light on this issue in the
literature.
We investigate whether liquidity has signicant effect on stock
returns after controlling for well-known stock-return factors.
These well-documented factors are the FamaFrench three factors,
momentum, and the higher moment-coskewness factors. Although
these are well-known factors in explaining stock returns in the US,
their joint effect with liquidity is seldom studied in emerging and
Asian markets.
We adopt a time-series regression approach to study the re-
turn-liquidity relation by employing nine widely used liquidity
(illiquidity) proxies in our study. We adjust the stock returns by
(1) Turnover ratio: the average of the monthly number of shares
traded scaled by the average number of shares outstanding
over 3, 6, or 12 months before July.
(2) Trading volume: the average of the monthly value of shares
traded over 3, 6, or 12 months before July.
(3) Standard deviation of turnover ratio: the standard deviation
of monthly turnover ratio over the 3, 6, or 12 months before
July.
(4) Standard deviation of trading volume: the standard devia-
tion of monthly trading volume over the 3, 6, or 12 months
before July.
(5) The coefcient of variation of turnover: CV (=standard devi-
ation/average) of turnover ratio over the 3, 6, or 12 months
before July.
(6) The coefcient of variation of trading volume: CV (=standard
deviation/average) of trading volume over the 3, 6, or
12 months before July.
(7) Liquidity measure following Pastor and Stambaughs (2003)
method. Performs the following regression by months:
 K.S.K. Lam, L.H.K. Tam / Journal of Banking & Finance 35 (2011) 22172230
 
r 0i;d1;t hi;t /i;t r i;d;t ci;t sign r 0i;d;t  mi;d;t ei;d1;t ;
d 1; . . . ; DD > 15
ri,d,t is the return on stock i on day d in month t; r 0i;d;t r i;d;t  r m;d;t
where rm,d,t is the market return on stock i on day d in month t; mi,d,t
is the dollar volume for stock I on day d in month t;
Stocks with stock price less than $5 and greater than $1000 are
excluded.
The liquidity measure over 12 months before July is constructed
as follows:
X value-weighted monthly returns on the six portfolios are calcu-
^ ^
ci 1=N ci;t ; where N 12:
(8) Amihud illiquidity ratio: the daily ratio of absolute stock
return to its dollar volume, averaged over 3, 6, or 12 months
before July. This can be interpreted as the daily price
response associated with one dollar of trading volume, thus
serving as an approximate measure of price impact.
(9) The standardized turnover-adjusted number of zero-trading
days (refer to Liu (2006)) can capture multiple dimensions
of liquidity, such as trading speed, trading quantity, and
trading cost, with a particular emphasis on trading speed,
that is, the continuity of trading and the potential delay or
difculty in executing an order (four dimensions of liquidity
trading quantity, trading speed, trading cost, and price
impact).
Illiquidity Number of zero  trading days in prior 12 months
1=12  month turnover=Deflator  21
 12=NoTD
where 12-month turnover is turnover the prior 12 months, calcu-
lated as the sum of daily turnover over the prior 12 months; daily
turnover is the ratio of the number of shares traded on a day to
the number of shares outstanding at the end of the day; NoTD is
the total number of trading days in the market over the prior x
months; and Deator is chosen such that 0 < (1/(12-month turn-
over))/Deator < 1 for all sample stocks, and it is served as a tie-
breaker when two stocks have the same number of zero-trading
days. For our analysis, Deator is 200,000,000. The number is much
larger than the one used by Liu (2006) because some of our sample
stocks are traded very infrequently.
Appendix B. Formation of FamaFrench three factors and
momentum factor
Following previous studies, monthly return data on non-nan-
cial companies only with appropriate adjustments for capital
changes are used. We employ value-weighted market returns with
cash dividends reinvested as proxy for the market index. There are
two parts in the risk-free rate used in this study: the 1-month
Hong Kong prime rate from January 1981 to June 1988 and the
1-month Hong Kong Interbank Offer Rate (HIBOR) from July 1988
to June 2004. Two different risk-free rates are used because the
HIBOR is not available from PACAP before July 1988.
To avoid the so-called look-ahead bias, accounting data at the
scal year-end in calendar year t  1 are matched to stock returns
for the period between July of year t to June of year t + 1. Firm size
is measured by market capitalization or market value of equity. It
is dened as the product of stock price and the number of shares
outstanding at the end of June in year t. The book-to-market equity
(BM) is computed as the ratio between a rms book equity at the
scal year-end in calendar year t  1 and its rm size at the end of
December of year t  1. Thus, to be included in our sample, a rm
should have both stock price and number of outstanding shares for
2229
December of year t  1 and June of year t as well as book equity for
scal year t  1. In addition, we only include observations with
positive.
For each year from July of year t to June of year t + 1, stocks are
assigned into two portfolios of size (Small (S) and Big (B)) based on
their rm size at the end of June in year t. The same stocks are
independently sorted into three portfolios of BM (Low (L), Medium
(M), and High (H)) based on their BM. Six portfolios (S/L, S/M, S/H, B/
L, BM, and B/H) are then formed at the intersection of size and BM
and in a way of having approximately equal numbers of stocks. The
lated each month over the 12 months following portfolio forma-
tion. Repeating this procedure for every year results in 276
equally-weighted monthly returns from July 1981 to June 2004
for each of the six portfolios.
SMB (small minus big) is the simple average of the returns on
the small-stock portfolios minus the returns on the big-stock
portfolios:
S=L  B=L S=M  B=M S=H  B=H
SMB 1
3
Similarly, HML (high minus low) is the simple average of the returns
on the high-BM portfolios minus the returns on the low-BM
portfolios:
S=H  S=L B=H  B=L
HML 2
2
We follow Lher et al.s (2004) to construct the momentum factor.
For each month from July of year t to June of year t + 1, stocks are
ranked by their size and prior performance. The size is based on
the ME value at the end of June in year t whereas the prior perfor-
mance is based on the nominal stock return from July in year t  1
to May in year t. Excluding the most recent month return can atten-
uate the continuation effect caused by the bid-ask spread. Winners
(W) are the top 30% of the total stocks with the highest average
prior performance. Losers (L) are the bottom 30% of the total stocks
with the lowest average prior performance. Neutral are the remain-
ing 40% of the stocks. Six portfolios (S/L, S/M, S/W, B/L, BM, and B/W)
are formed at the intersection of size and prior performance. The va-
lue-weighted monthly returns on the six portfolios are calculated
each month over the 12 months following portfolio formation.
WML (winner minus loser) is the simple average of the returns on
the winner-stock portfolios minus the returns on the loser-stock
portfolios:
S=W  S=L B=W  B=L
WML 3
2
Appendix C. Comparison of time-series market volatilities
between Hong Kong and U.S
Time-series market volatilities are displayed for the Hong Kong
and US stock markets over the period from January 1980 to
December 2003. The Hong Kong stock market return is proxied
by the PACAP value-weighted market return with cash dividend
reinvested while the U.S. market return is proxied by S&P 500
Composite Index return. Following Zhang (2010), stock return
volatility (annualized) in month t is calculated based on the sum
of squared returns in the month and is dened as:
!0:5
X
Dt
12 mret2td ;
d1
where mret is market return, and Dt is the number of trading day in
month t.
2230 K.S.K. Lam, L.H.K. Tam / Journal of Banking & Finance 35 (2011) 22172230

1.4

1.4
1.2

1.2
Annualized daily volatility
1

1
.8

.8
.6

.6
.4

.4
.2

.2
0

0
1980m1 1985m1 1990m1 1995m1 2000m1 2005m1
Month

HK market volatility US market volatility

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