Asset Pricing Anomalies – Liquidity Risk Spreaders or Liquidity Risk Hedgers?

Abstract

A unified explanation of risk and mispricing in stock returns underpinned by their aggregate liquidity risk is presented. We argue alternating liquidity exposures depict two distinct investment preferences-hedging against aggregate liquidity risk or betting on it. A three-factor model capturing these return variations is developed. Results show that our parsimonious factor model outperforms the majority of the latest asset pricing models in explaining spreads on a broad set of anomalies. Crucially, we identify that the better performance of recent models is driven by the inclusion of factors that mimic liquidity risk hedging. The imposition of stringent temporal restrictions on competing factor models shows that our model leads the pack.

Keywords: risk, mispricing, aggregate liquidity risk, asset pricing models, intertemporal-CAPM

JEL Classification: G10, G12, G15