Pervasive Liquidity Risk

37 Pages Posted: 26 Jun 2007

See all articles by B. Espen Eckbo

B. Espen Eckbo

Tuck School of Business at Dartmouth; European Corporate Governance Institute (ECGI)

Oyvind Norli

BI Norwegian Business School - Department of Financial Economics

Date Written: November 2002


While there is no equilibrium framework for defining liquidity risk per se, several plausible arguments suggest that liquidity risk is pervasive and thus may be priced. For example, market frictions increase the cost of hedging strategies requiring frequent portfolio rebalancing. Also, liquidity risk is likely to play a role whenever the market declines and investors are prevented from hedging via short positions. Using monthly return data from 1963-2000, and a broad set of test assets, we examine six candidate factor representations of aggregate liquidity risk, and test whether any one of these are priced. The results are interesting. First, with the surprising exception of the recent measure proposed by Pastor and Stambaugh (2001), liquidity factor shocks induce co-movements in individual stocks' liquidity measure (commonality in liquidity). The commonality is similar to that found in the extant literature (Chordia, Roll, and Subrahmanyam (2000)), which so far has been restricted to a single year of data. Second, again with the exception of the Pastor-Stambaugh measure, the liquidity factors receive statistically significant betas when added to the Fama-French model. Third, maximum-likelihood estimates of the risk premium are significant for the measure based on bid-ask spreads, contemporaneous turnover, as well as the Pastor-Stambaugh measure, which exploits price reversals following volume shocks. Overall, the simple-to-compute, low-minus-high turnover factor first proposed by Eckbo and Norli (2000) appears to do as least as well as the other factor measures.

Keywords: Liquidity, Risk factor, Commonality

JEL Classification: G12

Suggested Citation

Eckbo, B. Espen and Norli, Oyvind, Pervasive Liquidity Risk (November 2002). Available at SSRN: or

B. Espen Eckbo (Contact Author)

Tuck School of Business at Dartmouth ( email )

Hanover, NH 03755
United States
603-646-3953 (Phone)
603-646-3805 (Fax)


European Corporate Governance Institute (ECGI)

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels

Oyvind Norli

BI Norwegian Business School - Department of Financial Economics ( email )

Nydalsveien 37
Oslo, N-0442
+4746410514 (Phone)

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