The Impact of Dividend Policy on Liquidity Risk Components Based on Covariance Decomposition

Corporate financial policies are used as tools to maximize shareholders’ wealth. Liquidity risk is one of the main systematic risks affecting the equity cost of capital. This study is to investigate the relationship between dividends and the components of systematic risk of liquidity to discover the influence on the named risk.
 
In this study, the Amihud measure of liquidity and the liquidity-adjusted capital asset pricing model were used to measure and decompose the components of liquidity risk. The decomposed measures of liquidity risk included 1) the covariance of stock illiquidity and market illiquidity, 2) the covariance of stock returns and market illiquidity, and 3) the covariance of stock illiquidity and Market returns.
 
Findings showed that, according to the theoretical expectation, the covariance of stock returns and market illiquidity and the covariance of stock illiquidity and market return increase when managers distribute more dividends. The results also indicated that contrary to the theoretical expectations, the covariance of stock illiquidity and market illiquidity increases by dividend distribution. In addition, according to the findings, dividends can be used to manage the liquidity risk of equity leading to lower costs of capital and higher shareholders’ wealth. Mismanagement of this type of risk can destroy the liquidity risk effect of dividends i.e. dividends should be used to affect the appropriate channel of dividend risk or appropriate covariance. Based on the results of this study, Under conditions of low liquidity or market recession, dividend growth can boost the stock return and enhance liquidity to some extent. However, in an illiquid market, despite its positive impact on stock returns, dividend growth cannot significantly increase the liquidity of the stocks.
 
The dividend policy of the previous year can reduce the comprehensive measure of liquidity risk for the next one and thereby reduce the expected return of investors. Since the comprehensive measure is multi-dimensional, to investigate separately the effect of dividend distribution on dimensions of liquidity risk, , , and  were investigated as components of liquidity beta. The results showed that dividends have a positive effect on the covariance of stock returns with market illiquidity ( ) and the covariance of stock illiquidity with market returns ( ), but contrary to theoretical expectations, they positively impact the covariance of stock illiquidity with market illiquidity ( ). Therefore, the channel of the effect of dividends on liquidity risk is  and . Indeed, within a market characterized by high illiquidity, companies offering generous dividends can potentially achieve higher returns. i.e., the covariance of stock returns and market illiquidity increases by dividend growth, and the risk component related to  will be decreased. During a market recession, companies that offer high dividends tend to encounter reduced illiquidity. This means that the covariance between the stock's illiquidity and the market return increases, leading to a decrease in the risk component associated with β^4. However, the results proved that in a market with high illiquidity, companies with high dividends cannot experience less illiquidity and reduce the risk dimension related to  liquidity.