The Impacts of Investor Sentiment on Liquidity and its Volatility: Evidence from Tehran Stock Exchange

Behavioral finance and market microstructure studies showed that investor sentiment has a positive and meaningful effect on liquidity. The purpose of this study is to investigate the effect of the Aggregate Sentiment Index (ASI) on liquidity and its volatilities and to examine the symmetry of news (shocks) on the Tehran Stock Exchange (TSE).

The available academic literature on liquidity proposes a wide set of indices and proxies to measure the different characteristics and dimensions of liquidity. In this study, four indices were employed to measure the various dimensions of liquidity including Transaction Cost, Volume-Based Measure (Trading Volume), and price-impact characteristics. Accordingly, the indices of turnover and trading volume were related to the transaction costs dimension, the Amihud illiquidity ratio was related to Volume-Based Measure (Trading Volume), and the High-Low Spread index was related to the price impact characteristic. Irrational Aggregate Sentiment Index (ASI) was formed using nine indirect (institutional) indices for measuring investor sentiment using Principal Component Analysis (PCA) and the GARCH model was used to investigate asymmetry. The E-GARCH and T-GARCH models were also employed to investigate the asymmetry of news (shocks).

The achieved results proved no significant relation between Turnover and Trading Volume indices but the strong impact of Amihud illiquidity ratio on investor sentiment. The findings also indicated the effects of shocks as asymmetric, i.e., optimistic (positive) shocks have greater effects than pessimistic (negative) shocks. Positive shocks cause a decrease in volatilities and an increase in liquidity.

Since Amihud’s illiquidity ratio is mostly affected by investor sentiment, policymakers can increase liquidity and decrease price volatility by controlling investor sentiment.