Asset Liquidity, Business Risk, and Beta

Abstract

Ferguson and Shockley (2003) demonstrate that by utilizing an equity-only proxy for the market index, an empirical single factor capital asset pricing model can lead to anomalies. As most extant studies, they show that information from firms' liabilities-equity structures, per se, leverage and distress, can improve factor pricing models. We show that information about asset structure, per se, firm's asset liquidity (i.e. cash holdings) and business risk, can be as important. We complement Ferguson and Shockley's (2003) leverage based-theory with a liquidity based-theory. We show that since by adding cash to the asset mix, a firm can substantially change the investment opportunity set, asset liquidity and business risk should affect asset prices. We first explore the pertinence of cash holdings theoretically. In our economy, the capital asset pricing model holds in theory. True betas are calculated with respect to aggregate wealth, and proxy betas might not take into account the cash holdings of the firms. We show that the true beta of the firm's assets is higher than a proxy beta of the firm's assets that 'forgets' the riskless assets of the economy. The true stock beta of a firm is also higher than the proxy stock beta that does not take into account the riskless assets held by the firms. By other words, systematic risk is underestimated when the economy's aggregate cash holdings are not recognized as a valuable asset. Our empirical analysis shows that asset liquidity and business risk are priced factors in an extended asset pricing framework of Fama and French. In the cross-section of firms, we regress the observed returns on the erroneous proxy betas and then show that the alpha and beta coefficient estimates from a one-factor model would be different from the CAPM pricing error and market price of risk, respectively. Furthermore, we also show that well-known pricing factors such as size, book-to-market, leverage, and distress could serve as instruments that capture asset liquidity (i.e. cash holdings) and business risk. We show that the asset liquidity or cash holdings and business risk have significant risk premiums. We also show that while our asset liquidity and business risk factors partly correlate with the Fama-French size and book-to-market factors, and the Ferguson-Shockley leverage and distress factors, they still represent uncaptured risk that significantly affects equity betas.