Liquidity And Asset Pricing: A New Measure Of Liquidity And Empirical Study

This paper indicates that the asset pricing model include not only the Fama-French three-factor but also liquidity and private information. Since liquidity is multidimensional, existing measures typically focus on one dimension of liquidity. A new liquidity measure was constructed in this paper. This measure captures multiple dimensions of liquidity, with particular emphasis on trading speed. The new liquidity measure is highly correlated with the commonly used bid-ask spread, turnover and return-to-volume measures. However, the new liquidity measure is materially different from existing measures. LMxUsing a new measure of liquidity, this paper documents a significant liquidity premium in the stock market. Neither the capital asset price model (CAPM) nor the Fama-French three-factor model can account for the liquidity premium. This paper shows that liquidity risk is priced and liquidity risk is important for asset pricing. The two-factor (market and liquidity) model well explains the cross-section of stock returns. In particular, the two-factor model accounts for the book-to-market effect. But the Fama-French three-factor model fails to explain the book-to-market effect.