Sentiment versus liquidity pricing effects in the cross-section of UK stock returns

Abstract

This study examines the asset pricing role of ‘sentiment risk’ in UK stock returns. We define sentiment risk as the sensitivity of stock returns to investor sentiment in financial markets. We incorporate a broad range of financial market variables in measuring financial conditions and use this as a proxy for market-wide investor sentiment. The paper distinguishes between rational and irrational (noisy) investor sentiment. Initial findings indicate a strong role for rational sentiment risk in the returns of FTSE All-Share stocks. However, further analysis reveals that this sentiment risk pricing is detected in the FTSE All-Share subgroup of FTSE small-cap stocks, while no evidence of sentiment risk pricing is found among the FTSE All-Share subgroups of FTSE 250 and FTSE 100 stocks. Our paper makes a key contribution by identifying that evidence of rational sentiment risk pricing disappears after controlling for the liquidity risk features of stocks. More generally, our findings point to a strong relation between sentiment risk and liquidity risk in stock returns and to the need for careful disentangling of sentiment versus liquidity effects.