Characteristic Liquidity, Systematic Liquidity and Expected Returns

We investigate whether the effect of liquidity on equity returns can be attributed to the liquidity level, as a stock characteristic, or a market wide systematic liquidity risk. We develop a CAPM liquidity-augmented risk model and test the characteristic hypothesis against the systematic risk hypothesis for the liquidity effect. We find that the two-factor systematic risk model explains the liquidity premium, and the null hypothesis that the liquidity characteristic is compensated irrespective of liquidity risk loadings is rejected. This result is robust over 1931-2008 data and sub-samples of pre-1963 and post-1963 data both in the time-series and the cross-sectional analysis