Abstract. Liquidity is key to the health and fluidity of financial markets. It is the ability to make trade assets in large quantities in a quick fashion without incurring large trading costs or moving the price. Stock market declines, especially during crises, compromise this ability as buyers flee the market. Suddenly, assets cannot be sold without massive unjustified price concessions. A liquidity risk has been realized.

Liquidity is one of the many risk factors that have been studied since Fama (1964), Mossin (1966) and Lintner (1965) laid the groundwork of factor investing by introducing the Capital Asset Pricing Model, which explains stock returns by their sensitivity to market risk. Since then, many factors have been added that have been found to be important determinants of stock returns. Liquidity too has been deemed as such by Amihud & Mendelson (1986), Pastor & Stambaugh (2003) and Acharya & Pedersen (2005) among others, who have all constructed measures to capture varying dimensions of liquidity. Even though some differing opinions have been presented, liquidity has generally been found to be an important state variable that impacts stock returns.

This study seeks to uncover the relationship between liquidity and stock returns in Finland and to reveal a possible liquidity premium. More specifically, we focus on the covariance between stock returns and changes in aggregate liquidity. A stock that is more sensitive to liquidity shocks, and therefore riskier, should provide higher returns. These liquidity shocks have historically been associated with financial crises and other major market downturns. Recently, the COVID-19 crisis shook the world and its financial markets. A deadly disease broke out and spread around the world rapidly. Governments around the world imposed quarantines and shut down businesses, which ground their respective economies to a halt. Stock markets collapsed and so did liquidity. The link between liquidity and crises makes the COVID-19 era an exceptionally interesting area of research. Thus, this study will also reveal the possible effect that the COVID-19 pandemic had on the relationship of stock returns and liquidity.

We adopt the liquidity series of Pastor & Stambaugh (2003) to use as the liquidity factor in our regression analysis. We finalize the model by adding additional control factors that account for risks unrelated to liquidity. The study uses monthly data from 2017–2022 and splits it into two sample periods: one for the pre-COVID period and one for the duration of the pandemic. The data is gathered from OMXH25 companies. The results suggest that there is no significant liquidity effect present. The coefficients of the liquidity factor correspond to prior research, but the results are not statistically significant. Similarly, the COVID-19 pandemic does not seem to influence the relationship between stock returns and liquidity. There are slight changes, but they are not statistically significant. These results may be caused in part by the limitations of this study. Additionally, it could be that the meaningful sources of liquidity risk arise from different liquidity dimensions than the one investigated in this study.