Does Commonality in Illiquidity Command a Risk Premium?

Abstract

This paper investigates whether investors are compensated for taking on commonality risk in equity portfolios. A large literature documents the existence and the causes of commonality in illiquidity, but the implications for investors are less understood. In a more than fifty year long sample of NYSE stocks, we find that commonality risk carries a return premium of at least 2.0 per cent annually. The commonality risk premium is statistically and economically significant, and substantially higher than what is found in previous studies. It is robust when controlling for illiquidity level effects, transaction costs, as well as variations in illiquidity measurement.

Keywords: commonality, commonality risk premium, asset illiquidity, systematic illiquidity, liquidity, effective tick

JEL Classification: G11, G12