Illiquidity and the Measurement of Stock Price Synchronicity

This paper demonstrates that measures of stock price synchronicity based on market model R² s are predictably biased downward as a result of stock illiquidity, and that previously employed remedies to correct market model betas for measurement bias do not fix R² . Using a large international sample of firm-years, we find strong negative and nonlinear relations between illiquidity and R² across countries, across firms, and over time. Because variables of interest frequently relate to illiquidity as well, we illustrate the consequences of not controlling for illiquidity in synchronicity research. More generally, we demonstrate the importance of using nonlinear control variable methods. Overall, we conclude that the illiquidity-driven measurement bias in R² provides an explanation for why prior research finds low-R² firms to have weak information environments, and suggest future research carefully evaluate the sensitivity of its results to nonlinear controls for illiquidity.