The pricing of systematic liquidity risk in stock markets

The question whether liquidity affects asset returns or not remains unresolved thus far. The absence of conclusive results in previous research suggests that asset pricing and liquidity have not been properly addressed in the standard literature. We consider that systematic liquidity shocks affect the optimal behavior of agents in financial markets. Indeed, fluctuations in various measures of liquidity are significantly correlated across common stocks. Accordingly, we propose the construction of a liquidity risk factor based on the ratio of absolute stock returns on euro volume suggested by Amihud (2002) and the approximately orthogonalizing procedure of Fama and French (1993), using it as an augmenting variable in their three-factor model.