Pervasive Liquidity Risk And Asset Pricing

Abstract

This paper constructs a measure of pervasive liquidity risk and its associated risk premium. I examine seven market-wide liquidity proxies and use Principal Compo-nent analysis to extract the first principal component, which captures 62 % of the standardized liquidity variance. The first common factor is rewarded with a signif-icant premium in cross-sectional asset pricing tests. Moreover, from 1971 through 2002, a difference in liquidity risk contributes 3.70 % to the difference in annualized expected return between high liquidity beta and low liquidity beta stocks. Liquidity risk is different from volatility effects, and provides a partial explanation for mo-mentum. Stock market liquidity risk is priced in the bond markets as well. Finally, there is a significant negative relation between liquidity and the conditional variance of monthly stock returns, and the liquidity measure subsumes traditional GARCH coefficients in the conditional variance.