What Drives the Liquidity Premium: Factors or Characteristics?

Abstract

We investigate whether the liquidity premium is better explained by the risk-based model or the characteristic-based model. Based on three widely-used liquidity measures that are supposed to reflect different aspects of liquidity, we find that liquidity as a characteristic carries a significant liquidity premium that is beyond the size and book-to-market effects. In addition, liquidity as a factor does not yield a significant risk premium beyond that provided by Fama and French’s (1993) three factors. Finally, in direct comparisons under a liquidity-augmented two-factor capital asset-pricing model, the liquidity premium is better characterized by a characteristic-based model rather than a risk-based model, especially for the Amihud (2002) liquidity measure and for the post-1964 period.

Keywords: Liquidity Premium, Factor Model, Characteristic-Based Model

JEL Classification: C1, G1, G2