Asset Pricing with Extreme Liquidity Risk
58 Pages Posted: 16 Oct 2016 Last revised: 22 Jun 2017
Date Written: June 21, 2017
Defining extreme liquidity as the tail of the illiquidity for all stocks, I propose a direct measure of market-wide extreme liquidity risk and find that it is priced cross-sectionally in the U.S. Between 1973 and 2014, the stocks with low extreme liquidity risk beta earned value-weighted average return of 5.88% annually higher than the stocks with high extreme liquidity risk beta, adjusted for exposures to the market return as well as the size and value factors. The extreme liquidity risk premium is different from that on aggregate liquidity risk documented in Pástor and Stambaugh (2003) as well as that based on the tail risk of Kelly and Jiang (2014). Extreme liquidity risk provides an advanced warning about extreme liquidity events, and it reliably outperforms aggregate liquidity measures in predicting future market returns. I incorporate extreme liquidity risk into Acharya and Pedersen (2005) framework and find new supporting evidence for their liquidity-adjusted capital asset pricing model. I explore potential economic mechanisms through which the rare and large fluctuations in stock-level liquidity are priced.
Keywords: Asset pricing; extreme liquidity risk; cross section of returns
JEL Classification: G1, G11, G12
Suggested Citation: Suggested Citation