ABSTRACT
Baker and Stein (2002) develop a theoretical model that predicts a positive relationship between market liquidity and asset prices. Although previous studies establish plausible connections between liquidity and expected returns in the cross-section (Amihud and Mendelson, 1986; Vayanos, 1998), the purpose of Baker and Stein’s (2002) model is to explain the relation between liquidity and expected returns through time. Underlying their model are two fundamental assumptions: (1) irrational investors underreact to the information content of order fl ow and (2) short sale constraints prevent information-based arbitrage. “ e short-sales constraints imply that irrational investors will only be active in the market when their valuations are higher than those of rational investors-i.e., when their sentiment is positive and when the market is, as a result, overvalued” (Baker and Stein, 2002, p. 33). eir model predicts that while positive investor sentiment leads to high share turnover and overvaluation, negative investor sentiment will have no systematic impact on prices.
