Time-Varying Liquidity Risk and the Cross Section of Stock Returns

Watanabe, Akiko; Watanabe, Masahiro

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Time-Varying Liquidity Risk and the Cross Section of Stock Returns

Review of Financial Studies, Forthcoming

Posted: 6 Dec 2006

See all articles by Akiko Watanabe

Akiko Watanabe

University of Alberta - School of Business; University of Alberta - Department of Finance and Statistical Analysis

Masahiro Watanabe

University of Alberta - School of Business; University of Alberta - Department of Finance and Statistical Analysis

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Abstract

This paper studies whether stock returns' sensitivities to aggregate liquidity fluctuations and the pricing of liquidity risk vary over time. We find that liquidity betas vary across two distinct states, one with high liquidity betas and the other with low betas. The high liquidity-beta state is short lived and characterized by heavy trade, high volatility, and a wide cross-sectional dispersion in liquidity betas. It also delivers a disproportionately large liquidity risk premium, amounting to more than twice the value premium. Our results are consistent with a model of liquidity risk in which investors face uncertainty about their trading counterparties' preferences.

Keywords: time-varying liquidity beta, liquidity risk premium, preference uncertainty, cross-sectional asset pricing test, regime switching model

JEL Classification: G12

Suggested Citation: Suggested Citation

Watanabe, Akiko and Watanabe, Masahiro, Time-Varying Liquidity Risk and the Cross Section of Stock Returns. Review of Financial Studies, Forthcoming, Available at SSRN: https://ssrn.com/abstract=948888