This study examines the relationship between illiquidity premium and equity returns in Pakistani equity market for the period 2000:6 to 2007:6 by using Fama and French (1992 and 1993) methodology. This is the first study that explores the relationship between illiquidity premium and equity returns in Pakistan by employing a large sample of more than 250 stocks listed on the Karachi Stock Exchange. An analysis of the results reveals that illiquidity premium is priced by market and it is significantly negatively related to equity market returns. It means that high liquidity stocks earn higher return in comparison to low liquidity stocks. Traditional Capital Asset Pricing Model (CAPM) is found to be valid as market factor is significant in explaining portfolio returns. However, the explanatory power of the two-factor model is 5% higher than the explanatory power of conventional CAPM. These results are in line with the findings of Hwang and Lu (2007) for the UK market and Eun and Huang (2007) for the Chinese equity market. However, empirical evidence contradicts that of Amihud and Mendelson (1986) who argue that low liquidity stocks earn higher return as compensation for taking illiquidity risk. As illiquidity premium exists in equity markets, so decision makers should consider it along with market premium in making decisions regarding investment, financing and valuation of financial instruments. The results are important, in the sense, that they can facilitate investors in efficient resource allocation.

Liquidity is one of the main characteristics of securities in capital markets. Investors want a certain level of liquidity so that they can buy and sell securities without incurring significant losses. Therefore, investors want risk premium for securities that do not fulfill adequate liquidity criteria. Economic theory suggests that liquidity and equity returns have an inverse relationship. Investors demand higher returns from securities that have high liquidity risk, while they are ready to receive lower return from securities that have higher level of liquidity. Therefore, it can be said that importance of liquidity stems from the aspirations of shareholder to obtain higher reward for the higher risk. It is generally agreed that liquidity can influence asset returns. In recent years, liquidity has attracted significant attention as a component of asset pricing models. In most of the studies, liquidity is considered as a risk factor with reference to asset pricing. The return related to this risk factor is the risk premium and investor expects to receive it as a result to taking that specific amount of risk. It is incorporated in Capital Asset Pricing Model (CAPM) as extensions to capture the impact of missing risk factors. Empirical literature identifies various proxies to capture the liquidity which include bid-ask spread, turnover ratio, dollar value traded, etc. The role of liquidity in explaining equity returns has been examined in various markets of the world, but there is no work, to the best of our knowledge, with reference to Pakistan. Therefore, the prime objective of this study is to explore the role of illiquidity premium in explaining equity returns in the Karachi Stock Exchange (KSE). This study also examines the relationship between illiquidity premium and returns of stylized portfolio. The stylized portfolios constructed and examined in the study include size-sorted portfolios, BMR-sorted portfolios, momentum-sorted portfolios, PE-sorted portfolios, and liquidity-sorted portfolios. This study uses turnover ratio as a proxy for liquidity and extracts illiquidity premium through difference between liquidity-sorted portfolios. This specific methodology is consistent with the conventional method employed to determine the size premium and value premium. However, this study is a first attempt in the context of Pakistan to employ this procedure for capturing illiquidity premium.

Financial Economics Journal, Illiquidity Premium, Stylized Equity Returns, Equity Market Returns, Capital Asset Pricing Model, Capital Markets, Karachi Stock Exchange, Liquidity Risk, Empirical Literature, Pakistani Equity Market, Illiquid Market, Regression Analysis, Capital Budgeting.