Liquidity Biases in Asset Pricing Tests
Elena N. Asparouhova
University of Utah - David Eccles School of Business
Arizona State University
University of California, Riverside (UCR) - Department of Finance and Management Science
Journal of Financial Economics (JFE), Forthcoming
Microstructure noise in security prices biases the results of empirical asset pricing specifications, particularly when security-level explanatory variables are cross-sectionally correlated with the amount of noise. We focus on tests of whether measures of illiquidity, which are likely to be correlated with the noise, are priced in the cross-section of stock returns, and document a significant upward bias in estimated return premia for an array of illiquidity measures in CRSP monthly return data. The upward bias is larger when illiquid securities are included in the sample, but persists even for NYSE/AMEX stocks after decimalization. We introduce a methodological correction to eliminate the biases that simply involves WLS rather than OLS estimation, and find evidence of smaller, but still significant, return premia for illiquidity after implementing the correction.
Number of Pages in PDF File: 50
Keywords: Bid-Ask Spreads, Liquidity, Asset Pricing, Beta Estimation
JEL Classification: G1, G2
Date posted: March 17, 2006 ; Last revised: August 17, 2009
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