Pervasive Liquidity Risk And Asset Pricing

Jing Chen∗

Job Market Paper

This Draft: Nov 15 2005

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.

∗
Columbia University, Graduate School of Business, New York, NY 10027 (email:[email protected]).
I am deeply indebted to my advisor, Professor Robert Hodrick, for his guidance and suggestions. I am
especially grateful for the insightful comments from Professor Andrew Ang, Geert Bekaert, Gur Huberman,
Michael Johannes, Charls Jones, Tano Santos, Maria Vassalou and seminar participants at Columbia
University.

1
1 Introduction
The importance of liquidity to asset pricing has received substantial attention recently.
Using a wide variety of liquidity measures, a number of empirical studies have investigated
the relation between the level of liquidity and expected returns.1 An important motive for
considering a market-wide liquidity measure as an important priced factor is evidence of
the existence of commonality across stocks in liquidity fluctuations.2 If liquidity shocks are
non-diversifiable and have a varying impact across individual securities, the more sensitive
an asset’s return is to such shocks, the greater must be its expected return. Whether and
to what extent liquidity has an important bearing on asset pricing is still in debate. The
first contribution of this paper is to try to resolve this debate.
The underlying difficulty for examining whether liquidity is important in asset pricing
is due to the fact that liquidity is unobservable. Liquidity generally denotes the ability of
investors to trade large quantities quickly, at low cost, and without substantially moving
prices.3 Different liquidity proxies have been employed in the literature. Eckbo and Norli
(2005) use stock turnover, Pastor and Stambaugh (2003) develop a return reversal measure,
and Acharya and Pederson (2003) investigate a price impact measure. These liquidity
measures capture only noisy information of liquidity. Hence, I use Principal Component
analysis to extract a common source of liquidity variation from seven different liquidity
proxies constructed from daily data. I find that the first principal component captures
62% of the standardized liquidity variance, and the first three components represent 87%
of the data variation. Moreover, the first component, with uniform positive loadings on
the seven liquidity measures, has a correlation coefficient of −52.8% with market volatility.
This is consistent with Pastor and Stambaugh’s (2003) finding that periods experiencing
adverse liquidity shocks generally coincide with high market volatility. The other principal
components are harder to interpret. This evidence clearly shows that the first principal
component captures the common source of time variation of the seven liquidity proxies.
I then use the first principal component in cross sectional asset pricing tests. Using
5 × 5 size and liquidity beta sorted portfolios, I find that the common liquidity factor
is rewarded with a significant risk premium. Except for the first principal component,
1
For example, Amihud and Mendelson (1986), Brennan and Subrahmanyam (1996), Brennan, Chordia,
and Subrahmanyam (1998), and Datar, Naik, and Radcliffe (1998) find that less liquid stocks have higher
average stock returns.
2
Chordia, Roll, and Subrahmanyam (2000) find significant market-wide liquidity comovement even after
controlling for individual liquidity determinants. Huberman and Halka (2001) document the existence of
systematic liquidity by finding positive correlations in liquidity innovations across portfolios. Hasbrouck
and Seppi (2001) identify only weak evidence of commonality in intraday liquidity fluctuations.
3
Hodrick and Moulton (2005) is the only theoretical paper so far that tries to capture these three
dimensions of liquidity.

2
the rest principal components are not priced in the cross-section of stock returns. These
results indicate that although there are different liquidity proxies, which are dramatically
different in theory, they share a common source of variation. I can thus extract this common
source of liquidity to be a unique liquidity risk measure. This paper makes a contribution
to attacking a related important question of what is the best way to represent pervasive
liquidity risk.
Only a few recent studies investigate whether liquidity risk is a pervasive priced risk
factor (for example, Eckbo and Norli (2005), Pastor and Stambaugh (2003), Acharya and
Pederson (2003)). These studies use different liquidity proxies. This paper is most closely
related to Eckbo and Norli (2002). Eckbo and Norli (2002) collect six liquidity proxies and
find that all liquidity factors, except for the return reversal measure, significantly affect the
cross section of portfolio returns. Instead of testing each liquidity proxy one by one, which
may be inconclusive due to inconsistency of the results, the principal component analysis
extracts a common source of liquidity variation. Armed with this unique liquidity risk
measure, I give a conclusive answer that liquidity does matter in asset pricing. 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.
Although the seven liquidity proxies are priced individually, they lose their significance in
the presence of the common liquidity factor. This evidence indicates that apart from the
common liquidity part, the remaining parts of the individual liquidity measures are not
priced in the cross-section of stock returns.
Liquidity risk provides a partial explanation for momentum. With the exception of
the two most winner portfolios (deciles 9-10), loadings on the liquidity factor increase
monotonically from the loser portfolios (decile 1) to decile 8. Adding liquidity spread to
Fama-French three factors reduces momentum spread’s alpha from 14.46% to 12.13% for
6/0/6 momentum portfolios, and from 16.68% to 14.12% for 12/0/3 momentum portfolios.
Models with the common liquidity factor are superior to models with momentum factor in
pricing the momentum portfolios. The common liquidity factor drives out the momentum
factor in the pricing of 6/0/6 momentum portfolios.
There are measures of aggregate uncertainty which decrease liquidity, increase risk aver-
sion, and cause stock prices to fall as risk premia rise. Since liquidity has a high correlation
coefficient of −52.8% with market volatility, one concern here is whether the extracted
liquidity factor captures only a volatility effect. I thus examine the role of liquidity in
cross-sectional pricing while controlling for volatility. Using the Ang, Hodrick, Xing, and
Zhang (2004) aggregate volatility measure, I find that the liquidity effect is robust to con-
trolling for a volatility effect. This evidence implies that although liquidity and volatility
are intimately related to each other, they have different cross-sectional pricing effects.
Stock liquidity risk is also priced in the bond markets. I interpret this result as evidence

3
for a ”flight to quality” effect, which is consistent with Pastor and Stambaugh’s (2003)
findings. By classifying samples according to their market-wide return reversal liquidity
measure, Pastor and Stambaugh find that months in which liquidity drops severely tend
to be months in which stocks and fixed-income assets move in opposite directions. Due to
this ”flight to quality” effect, it is natural to expect that stock market liquidity risk exerts
an effect on the bond markets, as well.
Finally, there is a significant negative relation between market liquidity and the condi-
tional variance of monthly stock returns, and the liquidity measure subsumes traditional
GARCH coefficients in the conditional variance. By incorporating the market liquidity in
the dynamics of the conditional variance of the stock return, I reexamine the risk-return
tradeoff and document insignificantly positive relation.
The rest of this paper is organized as follows. Section 2 describes the construction of
seven market-wide liquidity proxies. Section 3 conducts principal component analysis and
extracts the common liquidity factor. Section 4 presents the cross-sectional asset pricing
test results. In this section, I examine whether liquidity risk is priced in the cross-section of
stock market and bond market respectively. Furthermore, I investigate the relation between
liquidity and momentum effect, and relation between liquidity and volatility effect. Section
5 is devoted to examination of the relation between liquidity and the conditional variance
of the stock returns. Section 6 concludes.

2 Market Liquidity Proxies

The power of the asset-pricing tests is enhanced by using large samples. Hence, I concen-
trate in this paper on those liquidity proxies constructed from daily data, instead of from
high-frequency data which has a relatively short time period. Normally, the construction
of aggregate market-wide liquidity proxies starts with a definition of firm-specific liquidity,
and then aggregates to a market-wide liquidity proxy by taking the cross-sectional aver-
age after excluding the two most extreme observations at both ends of the cross-section.
Following Eckbo and Norli (2002), I construct six market liquidity proxies from daily data
from Jan 1963 to Dec 2002. I add one more liquidity proxy which is the illiquidity ratio of
Amihud (2002). In the construction of the proxies, only the NYSE and AMEX ordinary
common shares (CRSP share code 10 or 11) are included in the sample.

2.1 Bid-Ask Spread

The proportional bid-ask spread, typically calculated as the difference between the bid or
offer price divided by the bid-ask midpoint, is a widely used measure of market liquidity. It
directly measures the cost of executing a small trade. The spread contains two components.

4
The first component compensates market-makers for inventory costs, order processing fees,
and/or monopoly profits. This component is transitory since its effect on stock price is
unrelated to the underlying value of the securities. The second component, an adverse-
selection component, arises because market-makers may trade with unidentified informed
traders. In order to recover from loses to the informed traders who may have superior
information, rational market-makers in a competitive environment widen the spread to
recover profits from uninformed traders. As a common measure of liquidity, the bid-ask
spread has certain shortcomings. Hasbrouck (1991) points out that a tick size of 1/8 limits
the number of values the spread can take, thus price discreteness tends to obscure the effect
of liquidity shocks in the cross section of firms.4 Moreover, Brennan and Subrahmanyam
(1996) argue that the bid-ask spread is a noisy measure of liquidity because large trades
tend to occur outside the spread while small trades tend to occur inside, which means that
bid-ask quotes are only good for limited quantities.
People often use intraday data to compute bid-ask spreads. In order to get longer
time-series of bid-ask spreads data, I follow Eckbo and Norli (2002) to turn to a subset of
stocks. As pointed out by Eckbo and Norli (2002), for those stocks that are not traded on
a particular day, CRSP records bid and ask prices accordingly. Thus, in any given month
there exists a cross-section of stocks that have not been traded for one or more days during
the month. To avoid stale prices, only those stocks with at least 10 trading days during the
month and with stock prices exceeding $1 while below $1000 are included in the sample.
The proportional spread for stock i in month t is then given by
Di,t
1 X A
pspri,t = (pi,d,t − pB A B
i,d,t )/(0.5pi,d,t + 0.5pi,d,t ), (1)
Di,t d=1

where pA B
i,d,t and pi,d,t are the ask and the bid prices for stock i on non-trading day d in
month t, and Di,t is the number of non-trading days for stock i in month t. The market-
wide proportional spread is taken to be the cross sectional average of these stocks’ monthly
proportional spreads.
Eckbo and Norli (2002) identify a positive trend in the monthly market-wide propor-
tional spread. To detrend the series, the original market-wide proportional spread series is
scaled by ω1 /ωt , where ωt is the 24-month moving average of the spread over months t − 24
to t − 1, and ω1 is the market spread value for August 1962. This adjusted market-wide
proportional spread is denoted as
Nt
X
P SP Rt = (ω1 /ωt ) · (1/Nt ) pspri,t , (2)
i=1
4
This price discreteness problem is present only in historical data. Prices are now decimal.

5
where Nt is the number of stocks included in the cross sectional average in month t.
Since in the original P SP R measure, higher numbers represent less liquidity, I flip the
sign of P SP R so that a higher value represents higher liquidity.

2.2 Stock Turnover

Stock turnover is given by the ratio of trading volume to the number of shares outstand-
ing. It is a trading activity measure that is often used as a proxy for liquidity. Amihud
and Mendelson (1986) show that assets with higher spreads are allocated in equilibrium to
portfolios with (the same or) longer expected holding periods. They argue that in equi-
librium, the observed market (gross) return must be an increasing function of the relative
spread, implying that the observed asset returns must be an increasing function of the
expected holding periods. Given the fact that the turnover is the reciprocal of a represen-
tative investor’s holding period and is negatively related to other liquidity costs such as
bid-ask spreads, one can use it as a proxy for liquidity and the observed asset return must
be a decreasing function of the turnover rate of that asset. Intuitively, in an intertemporal
setting with zero transaction costs, investors will continuously rebalance their portfolios
in response to changes in the investment opportunity set. In the presence of transaction
costs, such rebalancing will be performed more infrequently, resulting in reduced liquidity.
However, Lee and Swaminathan (2000) question the interpretation of turnover as a proxy
for liquidity because the relationship between turnover and expected returns depends on
how stocks have performed in the past. More specifically, they find that high volume stocks
are generally glamour stocks and low volume stocks are generally value or neglected stocks.
Also high volume firms and low volume firms differ significantly in terms of their past
operating and price performance.
Similar to the construction of the market-wide proportional spread above, at the firm-
specific level, the monthly turnover measure is the average of daily share turnover:
Di,t
1 X
stovi,t = stovi,d,t , (3)
Di,t d=1

where stovi,d,t is the share turnover for stock i on day d in month t, and Di,t is the number of
observations for stock i in month t. I then aggregate by taking the cross-sectional average
of the monthly firm-specific turnover to get the market-wide turnover measure. Again, to
create a stationary series, the market-wide turnover is scaled by a factor v1 /vt , where vt
is the 24-month moving average of the market-wide turnover through months t-24 to t-1,
and v1 is the value of the turnover for August 1962. This adjusted market-wide turnover

6
is denoted as
Nt
X
ST OVt = (v1 /vt ) · (1/Nt ) stovi,t , (4)
i=1
where Nt is the number of stocks included in the cross-sectional average in month t.

2.3 Price Impact of Trade

2.3.1 Illiquidity Ratio
A natural measure of liquidity is a stock price’s sensitivity to trades. Kyle (1985) postulates
that because market makers cannot distinguish between order flow generated by informed
traders and by liquidity (noise) traders, they set prices as an increasing function of the order
flow imbalance which may indicate informed trading. This positive relation between price
change and net order flow is commonly called the price impact or Kyle’s λ. The illiquidity
ratio of Amihud (2002), which is defined to be absolute return divided by the dollar trading
volume, reflects the absolute (percentage) price change per dollar of trading volume, and
is a low frequency analog to microstructure high frequency liquidity measures. While the
bid-ask spread captures the cost of executing a small trade, the illiquidity ratio, as a price
impact proxy, captures the cost associated with larger trades. Furthermore, Hasbrouck
(2003) shows that the Amihud (2002) illiquidity ratio is the best available price-impact
proxy constructed from daily data. He uses microstructure data to estimate a measure
of Kyle’s (1985) λ and finds that its correlation with Amihud’s illiquidity ratio is 0.47 for
individual stocks and 0.9 for portfolios.
The monthly firm-specific illiquidity ratio is given by
Di,t
1 X
illiqi,t = |ri,d,t |/vi,d,t , (5)
Di,t d=1

where ri,d,t and vi,d,t are the return and the dollar volume (measured in millions of dollars)
for stock i on day d in month t, and Di,t is the number of observations for stock i in
month t. Then the market-wide illiquidity ratio is the cross-sectional average of individual
stocks’ illiquidity ratios in each month. Since there is a declining trend in the market-wide
illiquidity ratio series, the original series is adjusted by multiplying a scaling factor, mt /m1 ,
where mt is the total dollar value at the end of month t − 1 of the stocks included in the
cross-sectional average in month t, and m1 is the corresponding value for August 1962. The
scaled market-wide illiquidity ratio is denoted as:
Nt
X
ILLIQt = (mt /m1 ) · (1/Nt ) iliqi,t , (6)
i=1

7
where Nt is the number of available stocks in month t.
Again for ILLIQ, higher numbers represent less liquidity. For consistency, I flip the
sign of ILLIQ to represent a liquidity measure.

2.3.2 Return Reversal

Pastor and Stambaugh (2003) develop a return-reversal measure as another form of price
impact which reflects order-flow induced temporary price fluctuations. This measure is
motivated by the Campbell, Grossman, and Wang (1993) (CGW) model and its empirical
findings. In the CGW symmetric information setting, risk-averse market makers acco-
modate trades from liquidity or noninformational traders. In providing liquidity, market
makers demand compensation in the form of a lower (higher) stock price and a higher ex-
pected stock return, when facing selling (buying) order from liquidity traders. The larger
liquidity-induced trades, the greater compensation for the market makers, causing higher
volume-return reversals when current volume is high. This return reversal measure reflects
only temporary price fluctuations arising from the inventory control effect of price impact.
It does not capture the permanent effect on price arising from asymmetric information like
Amihud’s illiquidity ratio in equation (5). Llorente, Michaely, Saar, and Wang (2002) and
Wang (1994) show that information-motivated trading can weaken the volume-related re-
turn reversal and even produce volume-related continuations. Cooper (1999), and Lee and
Swaminathan (2000) provide empirical evidence for volume-induced return continuations.
The monthly firm-specific return reversal measure (henceforth referred to as PS) is
computed by running a regression using daily data within a month:
AR
rit+1 = γ0 + γ1 rit + ps$i [sign(ritAR ) × volit ] + ²it , (7)
AR
where rit+1 is the excess return with respect to the CRSP value weighted market return for
firm i on day t + 1, rit is the return for firm i on day t, and volit is volume in millions of
dollars. Firm months with less than 15 daily return observations are excluded. ps$ measures
the expected return reversal for a given dollar volume. The greater the expected reversal
is, the lower the stock’s liquidity. Therefore ps$ should be generally negative and larger in
absolute value when liquidity is lower. The cross-sectional average of monthly individual
stocks’ return reversal measures is the market-wide return reversal measure. Since there
is a declining trend in the absolute value of average return reversal, I follow Pastor and
Stambaugh and scale the series by nt /n1 , where nt is the total dollar value at the end of
month t − 1 of the stocks included in the cross sectional average in month t, and n1 is the
corresponding value for August 1962. The scaled market-wide return reversal is then given

8
by:
Nt
X
P S$t = (nt /n1 ) · (1/Nt ) ps$i,t , (8)
i=1

where Nt is the number of available stocks in month t.

2.3.3 Breen, Hodrick,and Korajczyk Measure

Instead of using order flow induced return reversal to measure liquidity, we can capture the
same liquidity effect by examining order flow on the the concurrent return. Based on this
idea, Breen, Hodrick, and Korajczyk (2000) (BHK) use high frequency data to construct
a measure of liquidity by regressing return on net turnover. As in Breen, Hodrick, and
Korajczyk (2000), I estimate firm-specific liquidity measure bhk$i by running the following
regression using daily data within a given month:

ritAR = ψ0 + ψ1 rit−1 + bhk$i [sign(ritAR ) × volit ] + ²it , (9)

bhk$ captures the extent to which a trade is executed without influencing the stock price.
If a stock is perfectly liquid, then it trades without any concurrent price movement, while
trades in illiquid stocks will lead to large concurrent price changes. Thus, the higher the
bhk$ is, the less liquid is the stock. Taking the cross-sectional average of all individual
stocks’ bhk$ measures and using the same scaling factor as in the PS measure, I denote the
adjusted market-wide BHK measure as BHK$t .
The above specifications in models (7) and (9) are somewhat arbitrary. Following Eckbo
and Norli (2002), I add two alternative measures pstoi and bhktoi by estimating models (7)
and (9) using turnover, instead of dollar volume volit , as an alternative order flow measure.
Aggregating individual stocks’ pstoi and bhktoi gives corresponding market-wide liquidity
measures. Again for stationarity concern, I scale them by ot /o1 , where ot is the 24-month
moving average, computed over months t − 24 through t − 1, of the average monthly
turnover. The two scaled market-wide measures are denoted as P Sto and BHKto . Same
as P SP R and ILLIQ, I flip the signs of BHK$ and BHKto to represent liquidity.

One potential problem using the scaling factors for ILLIQ, P S$ and BHK$ is that
they involve market values, which may contaminate the liquidity measures with a valuation
measure that may predict returns. To address this concern, I use an alternative scaling
factor o1 /ot for these three liquidity proxies, where ot is the 24-month moving average of
the corresponding liquidity measure over months t-24 to t-1, and o1 is the corresponding
value for August 1962. It turns out that the results are very robust. To conserve space, I
do not present the results using this alternative scaling factor.

9
2.4 Descriptive Statistics
Table 1 provides autocorrelations and contemporaneous cross-correlations for the seven
scaled market-wide liquidity proxies. The scaled proxies are generally highly persistent
with one-month autocorrelations ranging from 67% to 93%. The Pastor-Stambaugh return
reversal proxies are comparably less persistent with one-month autocorrelations of 19% and
26% for P S$ and P Sto respectively. Because I have transformed all the seven measures to
be liquidity measures, their pair-wise contemporaneous cross-correlations are all positive.
Figure 1 plots the time-series of the seven scaled market-wide liquidity proxies. Note
that these different liquidity proxies consistently indicate adverse liquidity shocks during
the 1970 political unrest, the 1973 oil crises, the stock market crash of October 1987, and
the Russian debt crisis of 1998. All these large fluctuations are coincident among the
different proxies although they are based on different theoretical arguments.

3 Principal Component Analysis

All seven individual liquidity measures capture some aspects of liquidity. Using principal
Component analysis, I can extract a common source of liquidity variation. Before principal
component analysis, I normalize the seven series of liquidity proxies to have mean zero and
unit variance. To avoid forward-looking bias, I implement a dynamic version of principal
component analysis. First, I do principal component analysis with the initial 36 months
to get the first observation of the principal components in Dec 1965. Then add one more
observation to the sample, redo the principal component analysis using the first 37 months
data, and append the last observation to the time series of the principal components. Keep
repeating this process until the end of the sample. By this way, the extracted principal
components at each time t incorporate only past information.
Table 2 shows the average loadings of the principal components and the corresponding
average weighting percentage for each principal component to explain the total liquidity
variation. The first principal component accounts for 62% of total liquidity variation, and
the first three principal components represent 87% of variation in the proxies. Moreover,
all seven liquidity proxies load positively on the first principal component, which clearly
shows that it tracks the common source of liquidity; while the loadings on the other principal
components do not have clear patterns.
Figure 2 plots the time series of the first principal component (noted as P C1 hereafter)
and market volatility, which is computed as the the within-month daily standard deviation
of the CRSP value-weighted return. From the figure, the first principal component clearly
tracks the common adverse liquidity shocks as presented by the seven liquidity proxies in
Figure 1. More specifically, the first principal component drops dramatically indicating low

10
liquidity during the 1970 political unrest time, the 1973 oil crises, the stock market crash
of October 1987, and the Russian debt crisis of 1998. These are also times of high market
volatility, I will take care in disentangling the two effects. Besides these common liquidity
shocks, the first principal component drops sharply over the recession of 1972-1974, the
Asian financial crisis in October 1997, and the burst of the hi-tech bubble in early 2000.
The first principal component increases sharply, indicating liquidity improvement, after the
decimalization of January 2001.
To obtain some intuition about the first principal component, the right panel of Table 2
lists the correlation between the first principal component and the seven individual liquidity
proxies, together with some market variables such as the market return, market volatility
and market trading volume. The market return (mktret) is the monthly value-weighted
return of NYSE-AMEX indices constructed by CRSP. For market volatility, I use two
measures. One is computed as the within-month daily standard deviation of the market
return, noted as mktvol. The other one is the VIX index from the Chicago Board Options
Exchange. Market trading volume (volume) is defined as the equally-weighted average
of NYSE-AMEX listed stocks’ trading volume. Since trading volume shows an increasing
trend, I detrend the series by multiplying a scaling factor ww1t , where wt is its 24-month
moving average over month t − 24 to t − 1, and w1 is the corresponding trading volume for
August 1962. The correlation of the first principal component with mktvol is −52.8%, and is
−66.7% with VIX. It is also positively correlated with volume with a correlation coefficient
of 44.5%, and mktret with a correlation coefficient of 32.2%. Thus, market liquidity is
up when the market is up, when trading volume increases, and when market volatility
decreases. The correlations imply that we can interpret the first principal component as
measuring the variation in liquidity that is highly correlated with market volatility.5
Table 3 examines how my stock market liquidity measure P C1, is related to prevailing
stock market and macroeconomic conditions. More specifically, I define market states by
aggregate market return (mktret), market volatility (mktvol) and market trading volume
(volume). I classify months with negative mktret as down markets and the remaining
months as up markets. Months with greater than average mktvol over the sample period
are classified as high volatility states and the rest as being in low volatility states. For
market trading volume, I define months with higher than average volume over the sample to
be in high trading activity states and the remainder as being in low trading activity states.
Following Fujimoto (2004), I define macroeconomic states by three economic indicators.
First, sample months are classified as being in expansionary or contractionary economic
5
Note that my findings from stock market here are quite consistent with what Fleming (2003) finds
from Treasury market. Using principal component analysis from seven liquidity measures for the on-the-
run two-year note in Treasury market constructed from high-frequency data, Fleming finds that the first
principal component measures variation in liquidity that is correlated with price volatility.

11
regimes according to the NBER business-cycle classification. Second, months with falling
(rising) Federal Reserve discount rates are defined as expansionary (restrictive) monetary
regimes. Third, months are classified into high probabilities of future recession (greater
than 20%) and low probabilities of future recession (equal to or less than 20%) based on
Stock and Watson’s (1989) Experimental Recession Index.
By comparing the stock market liquidity measure, P C1, across these different market
and macroeconomic states, Table 3 clearly shows that market liquidity is indeed lower under
declining stock market conditions as well as declining macroeconomic environment. P C1
is significantly lower (indicating lower market liquidity) in down markets, high volatility
state as well as low trading activity state. Besides this, P C1 is also significantly lower
in declining macroeconomic environment, indicated by recession periods, restrictive mone-
tary regimes, and high probability of future recession periods. Moreover, the difference is
both statistically and economically significant. These results using the extracted common
liquidity measure P C1 is consistent with Fujimoto (2004) results by using three different
market liquidity proxies (P SP R, ILLIQ, P S$ ) respectively.

4 Asset Pricing Tests

4.1 Construction of Common Liquidity Factor
The first principal component is highly persistent, having a first-order auto-correlation
coefficient of 77%. To remove the information which is tracked by lagged observations and
thus construct a time series of innovations, I model the first principal component by an
AR model. The autoregressive order of 3 is chosen by the Bayesian Information Criterion.
Using the AR(3) model, I construct the innovation series L1t , which I define as the pervasive
liquidity factor:

P C1t = a + bP C1t−1 + cP C1t−2 + dP C1t−3 + L1t (10)

Figure 3 plots the time series of the innovations in the first principal component. It
shows that the innovations exhibit peaks indicating larger than normal shocks in periods
where there likely were shocks to liquidity, such as during the the 1973 oil crises, the
recession of 1972-1974, the stock market crash of October 1987, the Asian financial crisis in
October 1997, the Russian debt crisis of 1998, and the burst of the hi-tech bubble in early
2000. There are also many large (positive or negative) innovations which do not correspond
to macro events.

12
4.2 Is common liquidity risk priced in stocks?
This section is devoted to testing whether the common liquidity factor as constructed from
principal component analysis is priced in the cross section of stock returns.

4.2.1 Construction of Testing Portfolios

To isolate the size effect which maybe closely related to stock liquidity, I construct 5 × 5
size and liquidity beta sorted portfolios.
In each month, stocks are first sorted into 5 groups according to their previous month
size. Within each size quintile, I sort stocks into quintile portfolios based on their historical
liquidity betas. The portfolios are equally-weighted and rebalanced monthly.6 A series of
monthly returns on each of the 25 portfolios is obtained by linking post-formation returns
across time. Stocks’ historical liquidity betas are estimated by running the regression using
the most recent five years of monthly data:

ri,t = βi0 + βiM M KTt + βiS SM Bt + βiH HM Lt + βiL L1t + ²i,t , (11)

where ri,t denotes asset i’s excess return, M KT denotes the excess return on a broad market
index, and the the other two factors, SM B and HM L, are payoffs on long-short spreads
constructed by sorting stocks according to market capitalization and book-to-market ratio.7
To ensure that the portfolio formation procedure uses data available only as of the formation
date, in each formation month, the series of innovations L1t is recomputed from equation
(10) with past data.
Panel A of Table 4 reports the risk diagnostics of our constructed 5×5 size and liquidity
beta sorted portfolios. From the top panel of the table, half of the portfolios have significant
FF-3 alphas, indicating the poor performance of the Fama-French three factor model in
pricing the sorted portfolios. Except for the smallest and biggest size portfolios, the FF3
alphas of the High-Low β L spread are significantly positive across size quintiles (3.97(t =
2.59), 3.90(t = 2.57), 3.39(t = 2.26)). Examination of the post-ranking liquidity betas
shown in the bottom panel of the table demonstrates that the constructed portfolios provide
sufficient dispersion in liquidity loadings. The liquidity loadings of the High-Low spread are
significantly positive across all the size quintile portfolios (ranging from 0.47 to 0.60). The
average L1 loading of the High-Low spread (noted as LIQ) across the five size quintiles is
0.55 with a t-statistic of 3.84. This evidence supports the hypothesis that the extracted
common liquidity risk factor is a priced risk factor. Furthermore, the associated premium is
positive, in that stocks with higher sensitivity to the extracted liquidity factor offer higher
6
The results are robust to value-weighted portfolios.
7
I thank Eugene F. Fama and Kenneth R. French for making these variables available online.

13
expected returns. It is consistent with the notion that a pervasive drop in liquidity is
undesirable for investors, so that investors demand compensation for holding stocks with
greater exposure to this liquidity risk.

4.2.2 Estimating the Liquidity Risk Premium

I test asset-pricing models of the form

E[rt ] = BλF + β L λL , (12)

where E[rt ] denotes the vector of the expected excess return of the testing portfolios, B is a
factor loading matrix corresponding to the traded factors, and β L is a vector of factor load-
ings corresponding to the constructed common liquidity factor L1. λ’s are corresponding
risk premiums. The underlying data generating process is assumed to be:

rt = β0 + BFt + β L L1t + ²t , (13)

where Ft is a vector containing the realizations of the ”traded” factors, while L1t is the
constructed common liquidity factor, which is not a traded factor. For the traded factors
Ft , in addition to the standard Fama and French (1993) factors M KT , SM B and HM L,
I include the momentum factor U M D.8
I use the stochastic discount factor approach and estimate λL by GMM method. Table 5
reports the results. I estimate the risk premium for L1 together with the Fama-French three
factors in Model I. Model II includes the additional factor U M D. The significantly positive
premium on HM L indicates the presence of value effect in the testing assets. The premiums
on M KT and SM B are insignificant, indicating poor performance of these two factors in
explaining the cross section of returns on the testing assets. The price of the common
liquidity factor L1 is significantly positive at the 1% level. When I include the additional
U M D factor, L1 remains significant, while U M D is not priced. This confirms what we
observe from the examination of testing portfolios in previous subsection: a pervasive drop
in liquidity, as indicated by decreasing value of L1, is undesirable for the representative
investor, so that the investor requires compensation for holding stocks with higher exposure
to the liquidity factor. The results suggest that the common liquidity factor seems to be
important in explaining the cross section of expected stock returns.
Since the extracted common liquidity factor is not a traded factor, the estimated risk
premium is subject to the scaling problem. However, combined with the factor loading β L ,
8
UMD is the momentum factor constructed by Kenneth French. In construction of the UMD, they use
six value-weighted portfolios formed on size and prior (2-12) returns. UMD is the average return on the
two high prior return portfolios minus the average return on the the two low prior return portfolios.

14
we can say a little more about the contribution of liquidity risk to asset i’s expected return,
βiL λL . From the risk diagnosis of the constructed testing portfolios reported in Table 4,
the High-Low liquidity-beta spread has a significantly positive loading of 0.55 on L1 after
controlling for size. Given the estimated risk premium of 0.56% in Table 5, the difference in
annualized expected return between high β L and low β L portfolios that can be attributed
to a difference in liquidity risk is 0.0056 × 0.55 × 12 = 3.70(%).

4.2.3 Liquidity Level vs. Liquidity Risk

The above evidence suggests that liquidity risk is an important risk factor in the cross-
section of stock returns. A natural question is whether the associated risk premium is due
to the liquidity level, rather than liquidity risk per se. To address this question, I conduct
simple examination to see whether the stocks with high liquidity risk tend to be illiquid.
Panel B of Table 4 reports the size, turnover, and illiquidity ratio of the constructed
5× 5 size and liquidity beta sorted portfolios. Within each size quintile, there is an inverted
U-shape pattern in size across the five β L portfolios. The two extreme (lowest and highest)
β L portfolios have smaller size than the middle portfolios. And the highest β L portfolios
have almost the same size as the lowest β L portfolios. The turnover from the lowest β L
to the highest β L portfolios exhibits U-shape within each size quintile. The two extreme
β L portfolios tend to have higher turnover, and the turnover difference between these two
portfolios is mixed. For the two smallest size groups, highest β L portfolios have higher
turnover, indicating better liquidity than the lowest β L portfolios. While for the rest three
size groups, the situation goes the opposite way. There is no clear pattern in the illiquidity
ratio across the five liquidity beta portfolios. In general, the lowest β L portfolios have
highest illiquidity ratio, indicating lower liquidity than higher β L portfolios. This means
that the stocks with low liquidity risk actually tend to be illiquid.
The evidence from the above examination clearly shows that it is really liquidity risk
to contribute to the risk premium, not the liquidity levels.

4.2.4 Are the Rest Principal Components Priced?

So far, I have only examined the importance of the first principal component in the cross-
section of stock returns. An immediate question is to ask whether the other principal
components are priced in the stock returns.
Following the same procedure in the examination of the first principal component, I first
construct the innovation series (noted as L2 to L7) from AR model for each of the principal
components. The testing assets for each of the principal component are constructed by
forming the 5 × 5 size and corresponding liquidity beta portfolios. Table 6 reports the
examination results. The model specification is F F 3 + Liquidity Factor, and the risk

15
premiums are estimated by GMM.9 From the second principal component onwards, none
of them are rewarded with significant risk premiums. It clearly shows that except for the
first principal component, the rest principal components are not priced in the cross-section
of stock returns.
This evidence indicates that the first principal component does a good job to capture the
common source of liquidity variation, thus representing a valid pervasive liquidity measure.

4.2.5 Liquidity and Momentum

Pastor and Stambaugh (2003) document that the momentum factor’s importance in an
investment context is reduced significantly by the inclusion of their liquidity risk spread.
Moreover, they find that momentum’s alpha is cut nearly in half by their liquidity risk
spread. Korajczyk and Sadka (2003) find that momentum profits are greatly reduced after
considering trading costs. Given this evidence, I investigate the extent to which liquidity
can explain the cross-sectional momentum effect. More specifically, I want to test whether
the common liquidity factor can drive out the momentum factor in the pricing of momentum
portfolios.
The construction of equally-weighted J/0/K momentum decile portfolios follows the
methodology of Jegadeesh and Titman (1993). Specifically, at the beginning of each month
t, stocks are ranked in ascending order based on their cumulative returns in the past J
months. Port 1 is the worst loser portfolio, and Port 10 is the best winner portfolio. Based
on these rankings, ten equally-weighted decile portfolios are formed and held for K months.
In each month t, the weights on K1 of the stocks in the entire portfolio are revised and the
rest are carried over from the previous month. The monthly rebalanced equally-weighted
portfolio returns are then recorded. I use 6/0/6 and 12/0/3 momentum portfolios as these
are most successful strategies according to Jegadeesh and Titman (1993).
I first investigate the extent to which the abnormal return of the momentum spread is
reduced by including the liquidity risk factor. Since I am running time-series regression, I
use the liquidity spread LIQ controlling for size as the liquidity risk factor. Table 7 reports
the liquidity loadings and alphas for the momentum decile portfolios when regressed on
the Fama-French three factors plus LIQ. Interestingly, with the exception of the two most
winner portfolios (deciles 9-10), loadings on the liquidity factor increase monotonically from
the loser portfolio (decile 1) to decile 8. The negative weight of the loser portfolio indicates
that it pays off positively when the market liquidity is low. Hence, this is consistent with
a positive price of liquidity risk. People do not like stocks that have ρ(r, L1) > 0, i.e.,
the stocks that have low payoffs in illiquidity states. Thus investors demand a higher risk
premium for those stocks whose returns are positively correlated with the common liquidity
9
The results are robust to model specification of F F 3 + U M D + Liquidity Factor.

16
factor. This goes to the correct direction in explaining the positive abnormal returns of the
winner portfolios and negative abnormal returns of the loser portfolios. As a result, the
Winner-Minus-Loser spread loads significantly positively on the liquidity factor LIQ (0.77
for the 6/0/6 momentum spread and 0.84 for the 12/0/3 momentum spread). Comparing
the alphas with respect to the FF3 factors and F F 3 + LIQ, we can see that adding LIQ
generally reduces the magnitude of abnormal returns across the decile portfolios. As a
result, the 10-1 momentum spread’s annualized alpha is reduced by adding the liquidity
factor LIQ. The 6/0/6 momentum spread’s alpha is reduced from 14.46% to 12.13%,
and the alpha for the 12/0/3 momentum spread is reduced from 16.68% to 14.12%. The
alphas for the momentum spreads remain significantly different from zero after including
the liquidity factor LIQ. This evidence indicates that liquidity risk provides a partial
explanation for momentum.
Table 8 presents the results testing whether the common liquidity factor can drive out
the momentum factor. In order to evaluate and compare the performance of different model
specifications, I perform Hansen’s (1982) over-identification J-test, and compute Hansen
and Jagannathan (1997) distance measure (HJ-distance). Let gT (b) be the model implied
moment conditions, S be the covariance matrix for gT (b), the over-identification J-test is

T JT = T gT (b̂)0 S −1 gT (b̂) −→ χ2 (#moments − #paramters) (14)

Assuming an asset pricing model provides a pricing kernel proxy y, and m is the true
pricing kernel, the HJ-distance is defined as

δ = minm∈L2 ||y − m||, s.t. E(mR) = P, (15)

where R is the asset return, and P is the corresponding price. Solving the minimization
problem, the HJ-distance is

δ = [E(yR − p)0 E(RR0 )−1 E(yR − p)]1/2 (16)

The HJ-distance uses the inverse of the covariance matrix of asset returns as the weighting
matrix. It is invariant across models, making HJ-distance suitable for model comparisons.
To examine explicitly the ability of the liquidity factor L1 to absorb the pricing information
in the the momentum factor U M D, I also perform Newey-West’s (1987) ∆J test. I call
the model specification that includes both L1 and U M D as the ”unrestricted model”. The
”restricted model” is the one that includes only the liquidity factor L1. The difference in
the J functions from the two model specifications is chi-square distributed:

T J(restricted) − T J(unrestricted) ∼ χ2 (# of restrictions). (17)

17
 Considering the 6/0/6 momentum portfolios in Panel A of Table 8, we notice that both
the common liquidity factor and the momentum factor are rewarded with significant risk
premiums respectively. Interestingly, the model specification of F F 3 + L1 passes both the
optimal GMM over-identification J test and the test of HJ-distance equals zero, while the
model F F 3 + U M D fails to pass either of the over-identification J test or HJ-distance
test. When I include both the liquidity factor L1 and the momentum factor UMD, the
momentum factor’s risk premium becomes insignificantly different from zero. The ∆J
test indicates that once we take into account the liquidity risk factor, adding momentum
factor does not improve the model performance in pricing the 6/0/6 momentum portfolios.
As for the 12/0/3 momentum portfolios in Panel B, the situation is somehow different.
First of all, the liquidity factor L1 and the momentum factor UMD still have significant
risk premiums, individually. But now, in pricing the 12/0/3 momentum portfolios, all the
model specifications in the table are rejected by both the optimal GMM over-identification
J test and HJ-distance test. Second, although the momentum factor UMD is still rewarded
with a significant premium in the presence of the liquidity factor L1, the ∆J statistic is
not significantly different from zero, indicating the redundancy of the momentum factor in
improving the model performance. F F 3 + L1 has a smaller HJ-distance than F F 3 + U M D
for both the 6/0/6 and 12/0/3 momentum portfolios. This clearly shows that F F 3 + L1 is
superior to F F 3 + U M D in pricing the momentum portfolios.
This evidence shows that liquidity risk is priced significantly in the cross-section of
momentum portfolios, and provides a partial explanation for momentum.

4.2.6 Examination of Individual Liquidity Proxies

Since the common liquidity factor captures the common source of liquidity variation from
seven liquidity proxies, it is natural to address how individual liquidity measures affect the
cross-section of stock returns. Moreover, once we account for the common liquidity factor
L1t , do other liquidity measures matter?
One can argue that the constructed 5 × 5 size and liquidity beta portfolios are biased
toward L1. For the investigation purpose, I use the 6/0/6 momentum portfolios as testing
assets.10 From Table 2, we notice that the individual liquidity measures are highly corre-
lated with the common liquidity factor. When I include both individual liquidity measures
and the common liquidity factor in the model specifications, I orthogonalize them against
the common liquidity factor L1t and use the orthogonalized part. Table 9 presents the risk
premiums estimated by GMM. The model specifications are F F 3 + Liquidity Measures.11
With the exception of the P SP R, all of the individual liquidity measures are priced in
10
The results are robust to 5 × 5 size and liquidity beta portfolios.
11
The results are robust to model specifications of F F 3 + U M D + Liquidity Measures.

18
the cross-section of 6/0/6 momentum portfolios. ST OV has a significant risk premium of
0.27% with a t-statistic of 2.56. P S$ and BHKto are priced significantly with a t-statistic
of 2.59 and 2.42 respectively, and ILLIQ, P Sto and BHK$ are priced at the 6% level.
This evidence confirms the findings in the previous subsection that liquidity risk provides a
partial explanation for momentum. In contrast, the FF3 factors M KT , SM B, and HM L
perform poorly in pricing the momentum portfolios, confirming a well-known result. After
we account for the common liquidity factor L1, all of the seven individual liquidity measures
lose their significance, while the common liquidity factor remains significant.
The results provide direct evidence that the common liquidity factor captures the com-
mon source of liquidity variation, and apart from this common liquidity part, the remaining
parts of the individual liquidity measures are not priced in the cross-section of 6/0/6 mo-
mentum portfolios.

4.2.7 Liquidity and Volatility

Increases in aggregate uncertainty tend to decrease liquidity, increase risk aversion, and
cause stock prices to fall as risk premiums rise. Note from Section 3, the correlation
of the first principal component L1 with stock price volatility mktvol is −52.8%, and
is −66.7% with V IX. Pastor and Stambaugh note that periods experiencing extreme
adverse liquidity shocks always coincide with high market volatility. One concern therefore
is whether the extracted liquidity factor captures only a market volatility effect. Ang,
Hodrick, Xing and Zhang (2004) (AHXZ) develop a risk factor based on aggregate volatility.
I thus move forward to examining the role of liquidity in cross-sectional pricing effect as
opposed to different responses to the increasing volatility. More specifically, I investigate
the relationship between cross-sectional effect of the common liquidity factor and AHXZ
aggregate volatility measure by examining whether the common liquidity factor L1 is still
priced significantly after controlling for the volatility factor.
To construct a set of test assets which have sufficient dispersions in the factor loadings, I
form 25 investible portfolios sorted by volatility beta β∆V IX and liquidity beta β L as follows.
At the beginning of each month from 1986 to 2002, common stocks are first sorted into five
quintiles based on their past β∆V IX . Within each quintile, stocks are then sorted into five
groups on the basis of their historical liquidity beta β L . The portfolios are value-weighted
and rebalanced monthly. β L is computed by the regression (11) using most recent five
years’ data. β∆V IX , which measures the sensitivity to aggregate volatility risk, is estimated
by the regression
i
rti = β0 + βM i i
KT · M KTt + β∆V IX · ∆V IXt + εt , (18)

using daily data over the past month, where ∆V IX is the daily changes in V IX.

19
 To estimate the factor premiums, the model specifications are F F 3 + F V IX + OL1
and F F 3 + U M D + F V IX + OL1. F V IX is the mimicking factor to track innovations in
V IX. According to AHXZ (2004), F V IX is constructed by estimating the coefficient b in
the following regression:
∆V IXt = c + b0 Xt + ut , (19)
where Xt represents the returns on the quintile portfolios sorted on past β∆V IX . The return
on the portfolio, b0 Xt , is the factor F V IX that mimics innovations in market volatility.
OL1 is the orthogonalized liquidity factor against the volatility factor F V IX. In this way,
I purge the liquidity factor L1 of potential volatility effect. The premiums are estimated
by GMM. Table 10 reports the results. Since F V IX is available from 1986, the sample
period is from Jan 1986 to Dec 2002. In model I, I estimate factor premiums from model
specification of F F 3 + F V IX + OL1. Model II includes the additional momentum factor
U M D. Panel A shows that after controlling the volatility effect F V IX, the orthogonalized
liquidity factor is still rewarded a significant risk premium. When adding the momentum
factor, the estimate of the risk premium on OL1 is slightly changed, moving from 1.06% in
model I to 0.8% in model II. The volatility factor F V IX is also significantly priced both
in model I and model II. The insignificance of the premiums on SM B and HM L indicates
the poor performance of these two factors during the sample period. When adding U M D,
both M KT and U M D are significantly priced. Panel B of Table 10 reports the factor
loadings on OL1 estimated from F F 3 + F V IX + OL1.12 In general, all the OL1 loadings
increase monotonically from low β L to high β L portfolios, and the sorted portfolios provide
disperse in the ex-post liquidity loadings.
The evidence from this subsection indicates that although the extracted liquidity mea-
sure is intimately related to the volatility, the role of liquidity in cross-sectional pricing
effect is not due to the volatility effect.

4.3 Is Common Liquidity Risk Priced in the Bond Market?

Pastor and Stambaugh (2003) document ”flight-to-quality” effect in months with excep-
tionally low liquidity. By classifying samples according to their return reversal liquidity
measure, they find that months with severe liquidity drops tend to be months in which re-
turns on stocks and fixed-income assets move in opposite directions. Using high frequency
data, Chordia, Sarkar, and Subrahmanyam (2003) explore liquidity movements in stock
and Treasury bond markets and find that a shock to quoted spreads in one market affects
the spreads in both markets. Motivated by this empirical evidence, it is natural to seek
whether stock market liquidity risk also exerts an effect on bond markets.
12
The loading patterns remain same when estimated from F F 3 + U M D + F V IX + OL1.

20
4.3.1 Treasury Bond Market
I first explore L1t as a pricing factor in the Treasury bond market. The reason that this
question is worth investigating is that if stock market liquidity risk is priced in the Treasury
bond market, it will be an important potential state variable for the modelling of the yield
curve.
I use CRSP Fama bond portfolio data. There are eight portfolios and the portfolio
maturity interval is six months. Only non-callable, non-flower notes and bonds are included
in the portfolios. The sample period is from May 1971 to Dec 2002. Panel A of Table
11 presents loadings on the stock liquidity risk factor and the estimated risk premiums.
The liquidity loadings are estimated in the presence of the Fama-French three factors.
Interestingly, the loadings on the stock liquidity factor increase monotonically from shorter
maturity portfolios to longer maturity portfolios, indicating higher liquidity risk in longer
maturity bonds. Five of the eight liquidity loadings are significant at the 6% level. The
stock liquidity factor L1 is priced in the treasury bond market at the 8% significance
level. The premium is 0.0132 with a t-statistic of 1.73. When pricing stocks and bonds
simultaneously, I use the 6/0/6 stock momentum portfolios for the stock market.13 Now the
common stock liquidity factor is significantly priced in the joint markets. The associated
premium is 0.0107 with a t-statistic of 3.35.14

4.3.2 Corporate Bond Market

Jong and Driessen (2004) investigate the role of liquidity risk in the pricing of corporate
bonds and find that the exposures of corporate bond returns to fluctuations in treasury
bond liquidity and equity market liquidity (proxied by illiqudity ratio) help to explain the
credit spread puzzle. Corporate bond market is a natural testing ground for the role of
liquidity in asset pricing because the returns on corporate bonds are correlated with both
the returns on the treasury bond market, and with returns on the stock market. I collect
data from Datastream on Lehman corporate bond indices. The credit rates range from
BAA to AAA. I use the ’intermediate maturity’ (average about 5 years) indices and the
’long maturity’ (average about 22 years) indices. The sample period is from Jan 1975 to
Dec 2002.
Using these corporate bond data, Panel B of Table 11 presents the test results. Consis-
tent with the findings of the treasury bond data, the corporate bond portfolios generally
have significant loadings on the stock liquidity risk factor. Five of the seven portfolios load
significantly on the stock liquidity factor at the 8% level. The stock market liquidity factor
L1 is significantly priced in the corporate bond market. The associated risk premium is
13
The result is robust to other stock portfolios in the previous subsection.
14
To conserve space, I do not report these numbers in the table.

21
0.0095 with a t-statistic of 2.33. When we estimate the model simultaneously with stock
portfolios, the common stock liquidity factor again receives significant risk premium.

The evidence in this subsection provides support that stock market liquidity risk exerts
an effect on bond markets as well.

5 Reexamination of the Relation Between the Ex-

pected Value and the Volatility of the Nominal Ex-
cess Return on Stocks
Fujimoto and Watanabe (2003) find a significant positive relation between illiquidity and
the conditional variance of monthly stock returns using three liquidity proxies (P SP R,
ILIQ, and P S$ ) respectively. Moreover, the illiquidity measures subsume traditional
GARCH coefficients in the conditional variance of the stock returns. This means that
stock liquidity is important in the dynamics of the conditional variance. In the literature,
there has been a long-standing debate on the tradeoff between risk and return. The em-
pirical evidence on this topic is conflicting. Standard GARCH-M models generally support
for a zero or positive relation. Using a modified GARCH-M model, Glosten, Jagannathan,
and Runkle (1993) document a negative relation between conditional expected monthly re-
turn and the conditional variance of monthly return. It is possible that the models for the
conditional volatility may not capture the time series properties of the excess stock returns
correctly. Given the evidence that market liquidity is important in the modelling of the
conditional variance of stock returns, I reexamine the risk-return relation by including the
market liquidity in the modelling of the conditional variance.
I revise the Glosten, Jagannathan, and Runkle (1993) modified GARCH-M model by
incorporating the stock liquidity measure P C1 in the dynamics of the conditional variance.
Let rt be the continuously compounded excess return on the CRSP value-weighted index
of stocks. The general GARCH-M model of the risk-return relation is given by:

rt = a0 + a1 ht−1 + ²t (20)
ht−1 = b0 + b1 ht−2 + β 0 xt−1 + g1 ²2t−1 + g2 ²2t−1 I{²t−1 <0} (21)

where Et−1 [²t ] = 0 and Et−1 [²2t ] = ht−1 . xt−1 is a vector of instrument variables which
are important in the conditional variance process. Here, I use continuously compounded
return on Treasury bills from Ibbotson & Associates and the common liquidity measure
P C1 in xt−1 . Glosten, Jagannathan, and Runkle (1993) show that the risk-free rate contains
information about future volatility within the GARCH-M framework. When including the

22
liquidity measure P C1 in the vector xt−1 , I orthogonalize it against the market excess
return. The indicator I{²t−1 <0} is 1 when ²t−1 < 0, and 0 otherwise. It is meant to capture
the asymmetric effect that positive and negative innovations to returns may have different
impacts on the conditional volatility.
Table 12 presents the estimate results from various model specifications. The first
two models demonstrate the importance of stock liquidity on the conditional variance of
stock returns. Model 1 is the standard GARCH(1,1) model without exogenous variables.
As what is usually found in the literature, both the ARCH and GARCH coefficients are
significant and their sum is close to but smaller than 1, indicating stationarity and high
persistence. The value of the GARCH coefficient 0.87 is much larger than the value of
the ARCH coefficient 0.05, implying long memory in the conditional variance. Model 2
incorporates the orthogonalized liquidity measure in the conditional variance equation.
The liquidity measure turns out to be significant at the 1% level and completely subsumes
the significance of the two GARCH related coefficients b1 and g1 . The negative coefficient of
P C1 (β2 ) indicates that lower market liquidity results in upward revisions of the conditional
variance. These results are consistent with Fujimoto and Watanabe (2003) Table 6 results,
and imply that the liquidity measure provides useful information about the variability of
the market return. I examine the risk-return relation from Model 3 onwards. The coefficient
we are focusing on is a1 . In Model 3, when I include both P C1 and rf in the conditional
variance process, only P C1 is significant. The risk-return relation a1 is positive but not
significantly different from zero. I encountered some problem in estimating the GARCH-
M models with asymmetric effect. So I only present part of the results for asymmetric
GARCH-M models. Model 4 is a standard asymmetric GARCH-M model. The negative
sign of g1 indicates that unexpected positive return decreases the conditional variance. The
t-statistic for g2 is 1.75, indicating weak evidence of asymmetric effect in the conditional
variance during our sample period. Model 5 is an extension of Model 4 by adding the
risk-free rate in the conditional variance process, and the results are qualitatively same.
In conclusion, by including the common liquidity measure P C1 in the dynamics of the
conditional variance of the stock return, I document zero or insignificantly positive relation
between risk and return. Note we should be cautious in interpreting this result because
there is always possibility that the model specifications used here are misspecified.

6 Conclusions
This paper demonstrates that a common liquidity factor, extracted from seven liquidity
proxies using principal component analysis, captures the common source of liquidity vari-
ation. My first contribution is providing a unique liquidity risk measure and resolving the
debate of whether and to what extent liquidity has an important bearing on asset pricing.

23
Armed with the extracted unique liquidity risk measure, I find that liquidity does matter
in asset pricing. Moreover, I find that from 1971 through 2002, a difference in liquidity risk
contributes 3.70% to the difference in annualized expected return between high β L and low
β L portfolios.
I investigate the extent to which liquidity can explain the cross-sectional momentum
effect. With the exception of the two most winner portfolios (deciles 9-10), loadings on the
liquidity factor increase monotonically from the loser portfolio (decile 1) to decile 8. Adding
liquidity spread to the Fama-French three factors reduces momentum spread’s alpha from
14.46% to 12.13% for 6/0/6 momentum portfolios, and from 16.68% to 14.12% for 12/0/3
momentum portfolios. Models with the common liquidity factor are superior to models
with momentum factor in pricing the momentum portfolios. The common liquidity factor
drives out the momentum factor in the pricing of 6/0/6 momentum portfolios.
I also examine the role of liquidity in cross-sectional pricing effect as opposed to different
responses to the increasing volatility. Using Ang, Hodrick, Xing and Zhang (2004) aggregate
volatility measure, I find that the liquidity effect is robust to controlling for the volatility
effect. This evidence implies that although liquidity and volatility are intimately related
to each other, they have different cross-sectional pricing effect.
I find that the stock liquidity risk is also priced in the bond markets. I interpret
this result as evidence for ”flight to quality” effect, which is consistent with Pastor and
Stambaugh’s (2003) findings.
Finally, by including the market liquidity measure in the conditional variance process
of GARCH-M models, I reexamine the risk-return relation and document insignificantly
positive relation.
The evidence presented in this paper suggests that liquidity risk is a pervasive risk factor,
and it is priced in both stock markets and bond markets. The future research agenda will
be incorporating the pervasive liquidity factor in the pricing kernel, and modelling the term
structure and stock markets jointly.

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27
Table 1: Descriptive Statistics for Monthly Aggregate Liquidity Measures. This
table presents descriptive statistics for seven scaled aggregate liquidity proxies: propor-
tional bid-ask spread (P SP R), turnover (ST OV ), illiquidity ratio (ILLIQ), Pastor and
Stambaugh return reversal (P S$ and P Sto ), and Breen, Hodrick, and Korajczyk measure
(BHK$ and BHKto ). The aggregate proxies are given by the cross-sectional average of the
corresponding individual-stock liquidity measures and then scaled for stationarity concern.
The construction of each measure is explained in Section 2. The sample period is from Jan
1963 to Dec 2002.

P SP R ST OV ILLIQ P S$ BHK$ P Sto BHKto

A. Correlations
P SP R 1.00
ST OV 0.30 1.00
ILLIQ 0.37 0.29 1.00
P S$ 0.18 0.15 0.29 1.00
BHK$ 0.30 0.23 0.82 0.43 1.00
P Sto 0.22 0.24 0.34 0.85 0.40 1.00
BHKto 0.27 0.44 0.55 0.40 0.68 0.47 1.00
B. Autocorrelations
Lag
1 0.9311 0.6662 0.8885 0.1854 0.7969 0.2607 0.9126
2 0.8673 0.4914 0.8563 0.2803 0.8016 0.2367 0.8222
3 0.8144 0.3841 0.8300 0.2036 0.7806 0.1690 0.7634
4 0.7452 0.2611 0.7780 0.1229 0.6957 0.0908 0.7048
5 0.6884 0.2171 0.7611 0.1902 0.7231 0.1315 0.6651
Table 2: Principal Component Analysis. This table presents the Principal Compo-
nent analysis result from the seven liquidity proxies: proportional bid-ask spread (P SP R),
turnover (ST OV ), illiquidity ratio (ILLIQ), Pastor and Stambaugh return reversal (P S$
and P Sto ), and Breen, Hodrick, and Korajczyk measure (BHK$ and BHKto ). The con-
struction of the seven liquidity proxies is explained in Section 2. The columns list the
principal components corresponding to the first to smallest eigenvalues. The loadings of
the principal components and the corresponding weighting percentage for each principal
component to explain the total liquidity variation are reported. The right panel reports
the selected correlations for the first principal component P C1 with the seven liquidity
proxies, market return (mktret), market volatility (mktvol and V IX) and market trading
volume (volume). The sample period is from Dec 1965 to Dec 2002.

Principal Component Analysis

P C1 P C2 P C3 P C4 P C5 P C6 P C7 corr P C1
P SP R 0.3071 0.1182 -0.2680 0.2504 -0.4593 0.0593 -0.0256 P SP R 0.4893
ST OV 0.3946 -0.0898 0.1703 -0.2568 -0.0303 0.0470 -0.0159 ST OV 0.5447
ILLIQ 0.3397 0.1569 -0.3237 -0.1979 0.0680 -0.1033 0.1235 ILLIQ 0.7355
P S$ 0.3527 -0.0435 0.2630 -0.1070 -0.0054 0.1821 0.0118 P S$ 0.6644
BHK$ 0.3857 0.1329 -0.3810 -0.1435 0.2646 0.0169 -0.0853 BHK$ 0.8087
P Sto 0.3872 -0.0727 0.3718 -0.0115 -0.0365 -0.1588 -0.0124 P Sto 0.7129
BHKto 0.4306 -0.1027 0.1627 0.3975 0.1147 -0.0450 0.0176 BHKto 0.8292
% variance mktret 0.3216
explained 0.6172 0.1535 0.1004 0.0669 0.0379 0.0175 0.0064 mktvol -0.5281
V IX -0.6671
volume 0.4446
Table 3: Average Market Liquidity at Different Stock Market and Economic
States. This table reports the average monthly liquidity levels at different stock market
and economic states. The market liquidity proxy is the extracted 1st principal component
P C1 as described in Section 3. Down (up) markets are the months with negative (zero
or positive) market return (mktret). High (low) volatility months are those with greater
than (equal to or less than) average market volatility (mktvol). High (low) trading activity
months are those with greater than (equal to or less than) average market trading volume
(volume). mktret, mktvol and volume are described in Section 3. The business cycle
classification is based on the NBER business cycle dates. Expansionary (contractionary)
monetary regimes are the months with falling (rising) Federal Reserve discount rates. Sam-
ple months are also classified into months with high (low) probability of recession if the
probability of future recession based on Stock and Watson’s (1989) Experimental Recession
Index exceeds 20% and otherwise. Robust p-values for difference in means are reported.
The sample period is from Dec 1965 to Dec 2002.

P C1
Market Return
(1) Down (N.Obs.=187) -0.7998
(2) Up (N.Obs.=293) 0.3039
P((2)-(1)=0) 0.01
Market Volatility
(1) High (N.Obs.=191) -1.0199
(2) Low (N.Obs.=289) 0.5138
P((2)-(1)=0) 0.001
Market Volume
(1) Low (N.Obs.=263) -0.6687
(2) High (N.Obs.=217) 0.4957
P((2)-(1)=0) 0.01
NBER Business Cycles
(1) Recessions (N.Obs.=66) -1.5616
(2) Expansions (N.Obs.=414) 0.1104
P((2)-(1)=0) 0.06
Monetary Policy Regimes
(1) Contractionary (N.Obs.=234) -0.7181
(2) Expansionary (N.Obs.=246) 0.3629
P((2)-(1)=0) 0.02
Experimental Recession Index
(1) High (N.Obs.=104) -1.0946
(2) Low (N.Obs.=376) 0.1543
P((2)-(1)=0) 0.07
Table 4: Properties of 5 × 5 Size and Liquidity Beta Portfolios. 5 × 5 size and
liquidity beta sorted portfolios are formed as follows. At the beginning of each month,
firms are first sorted into five groups by size. Within each size quintile, firms are sorted into
quintile portfolios according to their historical liquidity beta with respect to the constructed
liquidity factor L1, which is computed using the most recent five years of monthly data.
Panel A reports the risk diagnostics of the portfolios. The annualized Fama-French alpha
are reported in percentage. The loadings on the Fama-French three factors, M KT , SM B,
HM L, and the non-traded liquidity factor L1 are computed through a time-series multiple
regression of each portfolio on these factors. The numbers in square brackets are robust
Newey-West t-statistics. Panel B reports corresponding liquidity characteristics. size is
the logarithm of the market capitalization in millions of dollars. Turnover is reported in
percentage. The sample period is from Jan 1971 to Dec 2002.

Panel A: Risk Diagnostics

Low βL High High-Low
Size
Small 7.49 8.50 7.64 7.56 10.31 2.82
[2.15] [3.35] [3.24] [3.12] [3.70] [1.13]
Fama-French -5.19 -0.23 0.33 0.42 -1.22 3.97
[-2.90] [-0.19] [0.24] [0.32] [-0.71] [2.59]
alpha -3.42 0.91 1.52 1.79 0.48 3.90
[-2.77] [0.98] [1.68] [1.95] [0.43] [2.57]
-2.30 2.06 1.15 2.32 1.09 3.39
[-2.13] [2.41] [1.31] [2.61] [1.11] [2.26]
Big -1.78 0.07 0.43 0.26 0.51 2.29
[-1.63] [0.09] [0.54] [0.29] [0.58] [1.55]
Small -1.12 -0.59 -0.28 -0.32 -0.51 0.60
[-2.11] [-1.54] [-1.11] [-1.18] [-1.08] [2.23]
-0.67 0.00 0.17 0.17 -0.08 0.58
[-2.62] [0.04] [1.15] [1.20] [-0.40] [3.23]
L1 -0.44 -0.05 0.18 0.23 0.03 0.47
[-3.02] [-0.49] [1.59] [2.02] [0.20] [2.93]
loading -0.41 0.12 0.18 0.25 0.15 0.56
[-2.97] [0.94] [1.41] [1.80] [1.14] [3.01]
-0.32 0.14 0.20 0.29 0.22 0.54
Big [-2.23] [1.04] [1.52] [2.14] [1.82] [2.79]
 Table 4-Continued

Panel B: Liquidity Characteristics

Low βL High
Size
Small 1.59 1.69 1.74 1.73 1.65
3.15 3.18 3.18 3.18 3.15
size 4.26 4.28 4.30 4.30 4.27
5.48 5.52 5.52 5.51 5.48
7.33 7.49 7.53 7.45 7.24
Small 3.98 3.30 3.12 3.45 4.42
5.38 4.14 3.94 4.18 5.59
turnover 7.51 5.33 4.78 4.89 7.07
8.89 6.16 5.59 5.86 8.24
9.03 6.11 5.70 5.80 7.05
Small 74.69 62.18 48.86 49.34 61.63
5.89 4.90 4.64 4.43 4.88
illiquidity ratio 0.90 0.93 0.92 0.95 0.88
0.21 0.19 0.23 0.22 0.18
0.03 0.02 0.03 0.03 0.03
Table 5: Pricing Common Liquidity Risk with Cross-sectional Testings. This
table reports the factor premiums on 25 portfolios sorted first on size and then on liquidity
beta β L . β L is computed from the regression ri,t = βi0 +βiM M KTt +βiS SM Bt +βiH HM Lt +
βiL L1t + ²i,t using the most recent five years of monthly data. M KT is the excess return on
the market portfolio, SM B and HM L are the Fama-French (1993) size and value factors,
U M D is the momentum factor constructed by Kenneth French, and L1 is the common
liquidity factor constructed in Section 4.1. The risk premiums are estimated by GMM
method. Robust t-statistics are reported in square brackets. The sample period is from
Jan 1971 to Dec 2002.

M KT SM B HM L UMD L1
Model I 0.0058 0.0024 0.0101 0.0056
[1.6016] [0.9303] [2.8660] [3.3154]

Model II 0.0044 0.0030 0.0080 -0.0186 0.0070

[1.2180] [1.0598] [2.0253] [-1.9121] [3.0945]
Table 6: Examination of the Other Principal Components in the Pricing of Stock
Returns. This table reports the factor premiums on 25 portfolios sorted first on size and
then on liquidity beta β L . β L is computed from the regression ri,t = βi0 + βiM M KTt +
βiS SM Bt +βiH HM Lt +βiL Lt +²i,t using the most recent five years of monthly data. M KT is
the excess return on the market portfolio, SM B and HM L are the Fama-French (1993) size
and value factors, and L2 − L7 are the innovation series for the 2nd principal component to
the 7th principal component. The risk premiums are estimated by GMM method. Robust
t-statistics are reported in square brackets. The sample period is from Jan 1971 to Dec
2002.

Risk Premiums
2nd Principal Component
M KT SM B HM L L2
-0.0053 -0.0025 0.0181 -0.0014
[−2.0915] [-1.0288] [3.9935] [-0.7259]
3rd Principal Component
M KT SM B HM L L3
0.0035 0.0005 0.0167 -0.0021
[1.1547] [0.2056] [4.2634] [-1.3308]
4th Principal Component
M KT SM B HM L L4
-0.0030 -0.0034 0.0251 0.0016
[−0.8893] [-1.2955] [4.9509] [1.4290]
5th Principal Component
M KT SM B HM L L5
0.0020 -0.0008 0.0138 -0.0007
[0.6970] [-0.3374] [3.6328] [-0.6437]
6th Principal Component
M KT SM B HM L L6
-0.0024 0.0005 0.0185 0.0006
[−0.8109] [0.2318] [4.9603] [0.8876]
7th Principal Component
M KT SM B HM L L7
0.0018 0.0006 0.0151 -0.0002
[0.5711] [0.2668] [3.6485] [-0.4247]
Table 7: Alphas of Momentum Portfolios. This table reports the liquidity loadings
and alphas for the momentum decile portfolios when regressed on the three Fama-French
factors plus liquidity spread LIQ. LIQ is the liquidity spread controlling for size, which is
constructed from the 5 × 5 size and liquidity beta sorted portfolios. Alphas are annualized
and reported in percentage. The construction of 6/0/6 momentum portfolios in Panel A
and 12/0/3 portfolios in Panel B is described in Section 4.2.5. The sample period is from
Jan 1971 to Dec 2002.

DECILE PORTFOLIO
1 2 3 4 5 6 7 8 9 10 10-1
A. Momentum 6/0/6
FF3-α -8.91 -8.34 -4.71 -2.77 -0.76 0.23 1.39 2.27 3.81 5.55 14.46
[-3.05] [-4.89] [-4.00] [-3.07] [-0.96] [0.30] [1.71] [2.53] [3.47] [3.56] [4.66]

FF3+LIQ α -6.55 -7.35 -4.24 -2.62 -0.83 0.00 1.02 1.89 3.58 5.58 12.13
[-2.17] [-4.14] [-3.45] [-2.80] [-1.01] [0.00] [1.28] [2.10] [3.10] [3.34] [3.77]

LIQ loading -0.77 -0.32 -0.15 -0.05 0.02 0.07 0.12 0.13 0.07 -0.01 0.77
[-3.04] [-2.72] [-2.14] [-0.94] [0.46] [1.47] [2.26] [2.00] [0.86] [-0.07] [3.38]
B. Momentum 12/0/3
FF3-α -8.77 -9.74 -5.96 -2.74 -0.86 0.60 2.06 3.36 5.48 7.91 16.68
[-2.81] [-5.56] [-4.84] [-2.89] [-1.05] [0.76] [2.40] [3.42] [4.33] [4.62] [4.79]

FF3+LIQ α -6.29 -8.81 -5.55 -2.57 -1.00 0.26 1.72 3.03 5.17 7.83 14.12
[-1.98] [-4.95] [-4.39] [-2.59] [-1.20] [0.34] [2.00] [2.96] [3.83] [4.20] [4.00]

LIQ loading -0.81 -0.30 -0.14 -0.06 0.04 0.11 0.11 0.11 0.10 0.03 0.84
[-2.99] [-2.72] [-1.98] [-1.10] [0.99] [2.50] [1.65] [1.43] [1.05] [0.21] [3.33]
Table 8: Liquidity and Momentum. This table investigates the relation between liquid-
ity and momentum in the cross-section of stock returns. L1 is the common liquidity factor
described in Section 4.1. U M D is the momentum factor constructed by Kenneth French.
Risk premiums and associated t-statistics are presented. Optimal GMM over-identification
test statistics, HJ-distance, and associated p-values are also reported. ∆J test statistic
and associated p-value are for the null hypothesis that adding momentum factor U M D to
F F 3 + L1 does not help model performance in the pricing of momentum portfolios. Panel
A uses the 6/0/6 momentum portfolios as testing assets, while Panel B uses the 12/0/3
momentum portfolios. The sample period is from Jan 1971 to Dec 2002.

Panel A: 6/0/6 momentum decile portfolios

M KT SM B HM L L1 UMD over- HJ ∆J
identification test Distance
-0.0042 0.0112 -0.0007 0.0082 7.8210 0.1746
[−0.5136] [1.5121] [-0.1599] [2.3858] (0.2515) (0.4425)

0.0087 -0.0026 -0.0016 0.0075 16.8613 0.2347

[1.3435] [-0.4836] [-0.3681] [2.6105] (0.0098) (0.0066)

-0.0062 0.0131 0.0025 0.0081 0.0073 6.1212 0.1544 1.2183

[−0.7128] [1.6471] [0.4856] [2.2418] [1.5674] (0.2946) (0.4528) (0.2697)
Panel B: 12/0/3 momentum decile portfolios
M KT SM B HM L L1 UMD over- HJ ∆J
identification test Distance
0.0078 -0.0008 -0.0067 0.0081 16.3158 0.2905
[1.1964] [-0.1160] [-1.5699] [3.5158] (0.0122) (0.0141)

-0.0015 0.0050 0.0057 0.0105 24.6917 0.3203

[−0.2896] [1.3025] [1.5074] [3.7515] (0.0004) (0.0000)

0.0022 0.0053 0.0002 0.0068 0.0098 15.4812 0.2705 2.6976

[0.3633] [0.9282] [0.0532] [3.1026] [2.6193] (0.0085) (0.0086) (0.1005)
Table 9: Common Liquidity Factor and Individual Liquidity Measures. This ta-
ble investigates the relation between the common liquidity factor and individual liquidity
measures in the cross-section of stock returns. L1 is the common liquidity factor described
in Section 4.1. The seven individual liquidity measures are proportional bid-ask spread
(P SP R), turnover (ST OV ), illiquidity ratio (ILLIQ), Pastor and Stambaugh return re-
versal (P S$ and P Sto ), and Breen, Hodrick, and Korajczyk measure (BHK$ and BHKto ).
The prefix ”O” before each measure stands for the orthogonalized measure against the
common liquidity factor L1. Risk premiums and associated t-statistics are presented. The
6/0/6 momentum portfolios are used as testing assets. The sample period is from Jan 1971
to Dec 2002.

M KT SM B HM L P QSP R L1 OP QSP R
0.0114 -0.0034 -0.0053 0.0002
[1.5147] [-0.5030] [-1.2182] [0.2404]
0.0042 0.0025 -0.0056 0.0086 -0.0014
[0.3444] [0.2230] [-0.8031] [2.4274] [-1.0991]
M KT SM B HM L ST OV L1 OST OV
0.0161 -0.0107 -0.0054 0.0027
[2.2678] [-1.6086] [-1.1002] [2.5571]
-0.0006 0.0050 -0.0014 0.0079 0.0009
[−0.0621] [0.4825] [-0.2545] [2.1896] [0.7292]
M KT SM B HM L ILLIQ L1 OILLIQ
0.0066 -0.0005 -0.0082 0.0027
[0.8510] [-0.0760] [-1.6605] [1.8364]
-0.0050 0.0118 0.0015 0.0096 -0.0014
[−0.5158] [1.3595] [0.2653] [2.6067] [-0.6883]
M KT SM B HM L P S$ L1 OP S$
0.0006 0.0120 -0.0015 0.0006
[0.0640] [1.5683] [-0.2986] [2.5886]
-0.0058 0.0128 -0.0002 0.0098 0.0000
[−0.6099] [1.5119] [-0.0371] [2.8546] [0.0854]
M KT SM B HM L BHK$ L OBHK$
0.0054 0.0013 -0.0057 0.0012
[0.6163] [0.1708] [-1.2620] [1.9364]
-0.0062 0.0132 0.0018 0.0100 -0.0009
[−0.5695] [1.3584] [0.2441] [2.5125] [-1.0047]
M KT SM B HM L P Sto L OP Sto
0.0041 0.0055 -0.0021 0.0079
[0.5516] [0.8570] [-0.5097] [1.9787]
-0.0062 0.0121 0.0005 0.0097 -0.0037
[−0.6589] [1.3892] [0.0951] [2.7982] [-1.0336]
M KT SM B HM L BHKto L OBHKto
0.0042 0.0043 -0.0031 0.0003
[0.5486] [0.6092] [-0.7044] [2.4169]
-0.0057 0.0127 -0.0002 0.0097 -0.0000
[−0.5943] [1.5310] [-0.0370] [2.8524] [-0.3193]
Table 10: Liquidity and Volatility. This table reports the factor premiums on 25 port-
folios sorted first on volatility beta β∆V IX and then on liquidity beta β L . β L is com-
puted from the regression ri,t = βi0 + βiM M KTt + βiS SM Bt + βiH HM Lt + βiL L1t + ²i,t
using the most recent five years of monthly data. β∆V IX is estimated by the regression
rti = β0 + βMi i i
KT · M KTt + β∆V IX · ∆V IXt + εt using daily data over the past month.
M KT is the excess return on the market portfolio, SM B and HM L are the Fama-French
(1993) size and value factors, U M D is the momentum factor constructed by Kenneth
French, F V IX is the mimicking factor for aggregate volatility innovations, L1 is the com-
mon liquidity factor, and OL1 is the orthogonalized liquidity factor against F V IX. The
risk premiums are estimated by GMM method. Robust t-statistics are reported in square
brackets. The sample period is from Jan 1986 to Dec 2002.

Panel A: Factor Premiums

M KT SM B HM L UMD F V IX OL1
Model I 0.0110 -0.0024 -0.0046 -0.0957 0.0106
[1.5077] [-0.6034] [-1.0430] [-2.0172] [4.4660]

Model II 0.0186 0.0030 -0.0070 0.0243 -0.1406 0.0081

[2.1919] [0.7332] [-1.6575] [3.1341] [-2.6302] [3.4371]

Panel B: Ex-Post Factor Loadings on OL1

Pre-ranking on β L
1 low 2 3 4 5
Pre-ranking Low 1 -0.76 -0.14 0.12 0.17 0.57
on β∆V IX [-4.44] [-0.97] [1.06] [1.81] [2.36]
2 -0.36 -0.07 0.09 0.18 0.23
[-3.64] [-0.70] [1.18] [2.48] [2.59]
3 -0.41 0.08 0.07 0.17 0.32
[-4.92] [0.92] [0.76] [1.96] [3.65]
4 -0.61 -0.04 0.09 0.00 0.44
[-4.07] [-0.35] [0.82] [0.04] [3.17]
5 -0.76 -0.38 -0.02 0.25 0.53
[-3.76] [-3.26] [-0.16] [1.35] [2.77]
Table 11: Pricing Stock Market Liquidity Risk in the Bond Markets. This table
reports loadings on the stock liquidity risk factor and the estimated risk premiums. Panel A
uses the CRSP Fama bond portfolios, and Panel B uses the Lehman corporate bond indices
from Datastream. The suffix ”s” stands for ”intermediate maturity”, while ”l” stands for
”long maturity”. The liquidity risk factor L1 is the extracted common liquidity factor
from stock market. The construction is described in Section 4.1. The liquidity loadings
are estimated in the presence of the Fama-French three factors. Robust t-statistics are
reported in square brackets. The sample period is from May 1971 to Dec 2002 for Fama
bond portfolios, and from Jan 1975 to Dec 2002 for Lehman corporate bond indices.

Panel A: CRSP Fama bond portfolios

6m 12m 18m 24m 30m 36m 42m 48m
Loading 0.60 1.17 1.82 2.77 3.98 5.06 5.78 6.29
[1.91] [1.47] [1.44] [1.65] [1.93] [2.12] [2.14] [2.05]
M KT L1
Premium 0.0151 0.0132
[1.1047] [1.7348]

Panel B: Lehman corporate bonds

AAA(s) AAA(l) AA(s) AA(l) A(s) A(l) BAA(s)
Loading 0.0755 0.1164 0.0770 0.1238 0.0768 0.1085 0.0645
[2.21] [1.73] [2.26] [1.86] [2.22] [1.62] [1.81]
M KT L1
Premium 0.0155 0.0095
[1.7929] [2.3259]
Table 12: Estimated GARCH-M models for the Risk-return Relation. This table
presents the parameter estimates of the market-level GARCH-M models. rt is the con-
tinuously compounded excess return on the CRSP value-weighted index of stocks. The
general GARCH-M model of the risk-return relation is given by rt = a0 + a1 ht−1 + ²t ,
ht−1 = b0 + b1 ht−2 + β1 rf + β2 P C1t−1 + g1 ²2t−1 + g2 ²2t−1 I{²t−1 <0} , where Et−1 [²t ] = 0 and
Et−1 [²2t ] = ht−1 . rf is continuously compounded return on Treasury bills from Ibbotson &
Associates, and P C1 is the common liquidity measure. The indicator I{²t−1 <0} is 1 when
²t−1 < 0, and 0 otherwise. Robust t-statistics are shown in square brackets. The sample
period is from Dec 1965 to Dec 2002.

Model 1 Model 2 Model 3 Model 4 Model 5

a0 0.0623 0.0433 0.0056 0.1055 0.1360
[1.26] [1.00] [0.05] [0.59] [1.43]

a1 0.0533 -0.0370 -0.0647

[0.41] [-0.21] [-0.69]

b0 0.0763 0.9420 0.6165 0.4163 0.0771

[1.47] [ 4.89] [3.25] [1.11] [0.71]

b1 0.8728 0.0458 0.1246 0.5215 0.5386

[11.6] [0.269] [0.80] [1.36] [2.82]

β1 0.0997 0.1309
[1.58] [1.83]

β2 -0.4265 -0.3770
[-4.61] [-4.53]

g1 0.0537 -0.0028 0.0031 -0.0931 -0.1057

[2.01] [-0.18] [0.17] [-3.98] [-4.00]

g2 0.2819 0.3640
[1.75] [1.94]
-0.8
-0.6
-0.4
-0.2
0.0
-0.6
-0.4
-0.2
0.0
0.2
0.4

-3.0
-2.0
-1.0
0.0
-6.0
-4.0
-2.0
0.0
0.00
0.01
0.02
0.03
0.04

-0.12
-0.08
-0.04
0.00
0.04
-0.09
-0.06
-0.03
0.00
Jan-63
Jan-63 Jan-63 Jan-63 Jan-63 Jan-63 Jan-63
Jan-65
Jan-65 Jan-65 Jan-65 Jan-65 Jan-65 Jan-65
Jan-67 Jan-67
Jan-67 Jan-67 Jan-67 Jan-67 Jan-67
Jan-69 Jan-69
Jan-69 Jan-69 Jan-69 Jan-69 Jan-69
Jan-71 Jan-71 Jan-71 Jan-71
Jan-71 Jan-71
from Jan 1963 to Dec 2002.

Jan-71
Jan-73 Jan-73 Jan-73 Jan-73
Jan-73 Jan-73 Jan-73
Jan-75 Jan-75 Jan-75 Jan-75
Jan-75 Jan-75 Jan-75

Jan-77 Jan-77 Jan-77 Jan-77 Jan-77

Jan-77 Jan-77

Jan-79 Jan-79 Jan-79 Jan-79 Jan-79 Jan-79 Jan-79

Jan-81 Jan-81 Jan-81 Jan-81 Jan-81 Jan-81 Jan-81

Jan-83 Jan-83 Jan-83 Jan-83 Jan-83 Jan-83 Jan-83

Scaled BHKto
Scaled PSto
Scaled PS$
Scaled ILLIQ

Scaled BHK$
Scaled PSPR

Scaled STOV

Jan-85 Jan-85 Jan-85 Jan-85 Jan-85 Jan-85 Jan-85

Jan-87 Jan-87
Jan-87 Jan-87 Jan-87 Jan-87 Jan-87

Jan-89 Jan-89 Jan-89

Jan-89 Jan-89 Jan-89
Jan-89

Jan-91 Jan-91 Jan-91 Jan-91 Jan-91

Jan-91 Jan-91

Jan-93 Jan-93 Jan-93 Jan-93 Jan-93

Jan-93 Jan-93

Jan-95 Jan-95 Jan-95 Jan-95 Jan-95

Jan-95 Jan-95
Jan-97 Jan-97 Jan-97 Jan-97
Jan-97 Jan-97 Jan-97
Jan-99 Jan-99 Jan-99 Jan-99
Jan-99 Jan-99 Jan-99
Jan-01 Jan-01 Jan-01
Jan-01 Jan-01 Jan-01 Jan-01
ILIQ, BHK$ and BHKto have been flipped to represent liquidity. The sample period is
(BHK$ and BHKto ). Each series is given by the cross-sectional average of the correspond-
Figure 1: Aggregate Liquidity Measures. The figure plots the scaled time series of

(ST OV ), illiquidity ratio (ILLIQ), PS return reversal (P S$ and P Sto ), and BHK measure

ing individual-stock measures and then scaled for stationarity concern. The signs of P SP R,
seven aggregate market-wide liquidity measures: proportional spread (P SP R), turnover
Figure 2: First Principal Component. The figure plots the time series of the first
principal component extracted from the seven aggregate market-wide liquidity proxies.
The sample period is from Dec 1965 to Dec 2002.

PC1 MKT VOL(in %)

8.00

4.00

0.00
Dec-65

Dec-67

Dec-69

Dec-71

Dec-73

Dec-75

Dec-77

Dec-79

Dec-81

Dec-83

Dec-85

Dec-87

Dec-89

Dec-91

Dec-93

Dec-95

Dec-97

Dec-99

Dec-01
-4.00

-8.00

-12.00
Figure 3: Innovations in First Principal Component. The figure plots the time series
of innovations to the first principal component. The innovations are computed as residuals
from AR(3) model in equation (10). The sample period is from Mar 1966 to Dec 2002.

L1
4

0
Mar-66
Mar-69
Mar-72
Mar-75
Mar-78
Mar-81
Mar-84
Mar-87
Mar-90
Mar-93
Mar-96
Mar-99
Mar-02
-2

-4

-6

-8