The Pricing of the Illiquidity Factor’s Conditional Risk with Time-varying Premium
45 Pages Posted: 9 Sep 2016 Last revised: 27 Feb 2019
Date Written: February 21, 2019
We test the pricing of the systematic risk (β) of a traded illiquidity factor, the return premium on illiquid-minus-liquid (IML) stock portfolios, whose risk-adjusted return is positive and significant. We find that the risk premium of IML β is time-varying being higher in times of expected financial distress. In our main analysis, we find a positive and significant risk premium on conditional IML β that rises in times of financial distress, measured by the corporate bond yield spread, TED spread, or broker–dealer loans (including margin loans). The positive pricing of the conditional IML β remains significant after controlling for the unconditional and conditional βs of other commonly used pricing factors and liquidity-based factors and for common firm characteristics, including size and illiquidity.
Keywords: Illiquidity, Systematic Risk, Time-varying Risk Premium, Conditional Beta, Funding Illiquidity
JEL Classification: G12, G10
Suggested Citation: Suggested Citation