Illiquidity and the Measurement of Stock Price Synchronicity

Abstract

Prior research in accounting and finance uses stock price synchronicity, based on R2s from market model regressions, to measure stock price informativeness. The premise underlying this literature is that low levels of R2 are indicative of share prices reflecting more firm-specific information. Yet, empirical studies often find low R2 to be associated with variables that reflect a relatively weak information environment. Our study posits and provides evidence that stock illiquidity biases downwards the measurement of R2. Exploiting an exogenous shock to illiquidity, we demonstrate how reductions in illiquidity reduce this bias and cause increases in R2 measures. Using an international sample, we document that illiquidity is the primary determinant of the variation in R2 across and within countries. We demonstrate how failing to control for illiquidity in synchronicity research using the R2 measure can lead to biased coefficients that either reduce the power of tests or induce potentially false rejections of a null hypothesis. Lastly, we introduce a new method that can be used in testing changes in synchronicity around an event. This method circumvents the estimation of a market model and thereby minimizes the bias in the R2 measure induced by illiquidity.