Valuing Stock Liquidity: Theory and Evidence From the Collapse of Lehman Brothers

ABSTRACT This study examines the cross‐sectional relationship between stock return and stock liquidity (both level and risk) for the period when there was a huge decline in market‐wide funding liquidity from the collapse of Lehman Brothers. We propose a global game model to analyse the decisions of short‐term traders around the time Lehman Brothers went bankrupt and show that the effect of a liquidity shortage on the pressure to sell stocks increases as stock prices approach short‐term traders' loss limits. We also empirically test and verify our model prediction that illiquid and high‐liquidity‐risk stocks underperform more.