Liquidity Risk And Asset Pricing

The main purpose of this paper is to construct an illiquidity risk factor using the Amihud [Amihud, Y. (2002). Illiquidity and stock returns: Cross-section and time-series effects. Journal of Financial Markets 5: 31–56] illiquidity premium that shows the price response associated with one dollar of trading volume, and embrace this risk factor into CAPM and Fama-French Three-Factor Model to build new asset pricing models which include liquidity risk factor.This paper firstly introduced the definition and importance of liquidity, and clarified that liquidity is one of the most important risk factor in asset pricing. Then this paper made an all-round introduction of CAPM and Fama-French Three-Factor Model. By reviewing papers related to liquidity and asset pricing, it is proved that systematic liquidity risk factor should be included in asset pricing model.Moreover, this paper made an all-sided review of liquidity measure, and finally chose the most appropriate one: Illiquidity premium. Using this liquidity measure, this paper created a systematic risk factor: IMV, and made test on CAPM, Fama-French Three-Factor Model and CAPM+IMV, Three-Factor Model+IMV.The conclusion of this paper is that systematic illiquidity should be a key ingredient of asset pricing.