The Pricing of Liquidity Factors

Abstract

This paper examines the pricing of liquidity factors and the performance of liquidity-augmented factor models. Using the 1963-2023 US stock market data, we construct six liquidity factors based on liquidity costs (LIQ), liquidity commonality risk (COM), return sensitivity to market liquidity (RML), liquidity sensitivity to market return (LMR), liquidity sensitivity to market uncertainty (LMU), and liquidity sensitivity to macroeconomic shocks (LME). Of these factors, LIQ, COM, and LMU capture additional dimensions of risks that the Fama-French factors do not. We show that asset pricing models with a liquidity factor perform better than those with the size factor (SMB).

Keywords: JEL classification: G11, G12, G14 Liquidity, Asset pricing, Size effect, Fama-French factors, Risk-adjusted returns

JEL Classification: G11, G12, G14