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Liquidity Biases in Asset Pricing Tests

50 Pages Posted: 17 Mar 2006 Last revised: 17 Aug 2009

Elena N. Asparouhova

University of Utah - David Eccles School of Business

Hendrik Bessembinder

Arizona State University

Ivalina Kalcheva

University of California, Riverside

Date Written: August 2009

Abstract

Microstructure noise in security prices biases the results of empirical asset pricing specifications, particularly when security-level explanatory variables are cross-sectionally correlated with the amount of noise. We focus on tests of whether measures of illiquidity, which are likely to be correlated with the noise, are priced in the cross-section of stock returns, and document a significant upward bias in estimated return premia for an array of illiquidity measures in CRSP monthly return data. The upward bias is larger when illiquid securities are included in the sample, but persists even for NYSE/AMEX stocks after decimalization. We introduce a methodological correction to eliminate the biases that simply involves WLS rather than OLS estimation, and find evidence of smaller, but still significant, return premia for illiquidity after implementing the correction.

Keywords: Bid-Ask Spreads, Liquidity, Asset Pricing, Beta Estimation

JEL Classification: G1, G2

Suggested Citation

Asparouhova, Elena N. and Bessembinder, Hendrik and Kalcheva, Ivalina, Liquidity Biases in Asset Pricing Tests (August 2009). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=891615

Elena N. Asparouhova

University of Utah - David Eccles School of Business ( email )

1645 E Campus Center Dr
Salt Lake City, UT 84112-9303
United States

Hendrik (Hank) Bessembinder (Contact Author)

Arizona State University ( email )

PO Box 873906
Tempe, AZ 85207
United States

Ivalina Kalcheva

University of California, Riverside ( email )

900 University Avenue
Riverside, CA 92521
United States

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