Testing the LCAPM vs. Generalized Liquidity-Adjusted Asset Pricing: New Evidence and New Perspectives

Abstract

The Liquidity-adjusted Capital Asset Pricing Model (LCAPM) includes two specific testable predictions: (1) the coefficient on expected liquidity cost equals average turnover and (2) the coefficient on market beta equals the coefficient on net liquidity risk beta. By contrast, generalized liquidity-adjusted asset pricing models allow liquidity characteristics and/or liquidity risk factors without such parameter restrictions. We empirically test these alternative theories. In doing so, we expand the range of evidence in multiple ways. First, we extend forward and backwards in time to cover 80 years. Second, we analyze NASDAQ-listed stocks as well as NYSE/AMEX-listed stocks. Third, we analyze four alternative liquidity measures: (1) the Corwin and Schultz proxy, (2) closing percent quoted spread, (3) the Amihud proxy, and (4) zeros. Fourth, we analyze the impact of adding Fama and French/Carhart risk factors to the model. Our main finding is that both of these specific predictions of LCAPM are robustly rejected. This outcome supports generalized liquidity-adjusted asset pricing. Finally, we ask can the original LCAPM results be replicated? We qualitatively replicate most tables, but obtain mixed results for two tables. We make publicly available our SAS code and the resulting data files for both our new empirical tests and our replication.