Abstract
The recent asset pricing literature has largely neglected liquidity risk since the price-impact-based factor shows limited pricing ability. Using different liquidity factors, this paper evaluates the liquidity-risk-based models together with the non-liquidity-based ones. With the new testing procedures and the different testing portfolios, we find that the liquidity-augmented capital asset pricing model (LCAPM) performs well. It yields a significant liquidity risk premium robust to all the other models. The success of the LCAPM lies in the fact that the trading-discontinuity-based factor captures the systematic nature of liquidity risk. It shows that liquidity risk is priced highly during the down and turmoil markets, whereas all the other factors examined exhibit insignificant risk prices when market volatility is high. Our evidence indicates that liquidity risk matters and the LCAPM is preferable to use for investment decision making, financial market research and regulation.
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