The Pricing of the Illiquidity Factor's Systematic Risk

Abstract

We test the pricing of the systematic risk (β) of a factor of illiquidity, return premium, the return on illiquid-minus-liquid (IML) stock portfolios, whose risk-adjusted return is positive and significant. The expected return is higher for stocks with greater exposure to IML in times of low funding liquidity, that is, IML β conditional on funding illiquidity is positively and significantly priced. Funding illiquidity is proxied by the corporate bond yield spread or by loans made by broker–dealers (including margin loans) relative to total loans. The conditional IML β remains positively and significantly priced after controlling for the systematic risks of other liquidity factors and for firm characteristics, including illiquidity.