The Multiple Dimensions of Market-Wide Liquidity:Implications for Asset Pricing

Abstract

Recent research has suggested that the state of market-wide liquidity varies over time and that the covariance of returns with innovations in a market-wide liquidity state variable is priced. However, liquidity has multiple dimensions which incorporate key elements of volume, time and transaction costs and it is not clear which of these are important to investors. This paper estimates measures of market-wide liquidity along multiple dimensions and finds that each measure's innovations are correlated, that covariance of stock returns and innovations in each measure is priced, and combining the information in each measure improves the precision of estimated liquidity risk premia. I estimate the liquidity risk premium to be approximately 2-6% per year.

JEL Classification: G11, G12, G14