Liquidity and Asset Pricing Under the Three‐moment Capm Paradigm

Abstract

We examine whether the use of the three-moment capital asset pricing model can account for liquidity risk. We also make a comparative analysis of a four-factor model based on Fama-French and Pástor-Stambaugh factors versus a model based solely on stock characteristics. Our findings suggest that neither of the models captures the liquidity premium nor do stock characteristics serve as proxies for liquidity. We also find that sensitivities of stock return to fluctuations in market liquidity do not subsume the effect of characteristic liquidity. Furthermore, our empirical findings are robust to differences in market microstructure or trading protocols between NYSE/AMEX and NASDAQ. 2007 The Southern Finance Association and the Southwestern Finance Association.

Liquidity and asset pricing: Evidence from the Hong Kong stock market

“…Therefore, investors are willing to accept a lower expected return for higher positive coskewness if the market is also positively skewed. 9 We are aware of other studies that calculate value-weighted returns to the six size-liquidity portfolios for the construction of the liquidity factor (e.g., Keene and Peterson, 2007;Nguyen et al, 2007). Our results are robust to this alternative way to form liquidity factors.…”

“…We rebalance the portfolios at the end of June every year from 1981 to 2003. Following Keene and Peterson (2007) and Nguyen et al (2007), we use turnover ratio as our main proxy for liquidity and report our results given by the stock portfolios and liquidity factors formed by turnover ratio. We will discuss the results given by the liquidity factors formed by other liquidity proxies in Section 4.4.…”

“…If liquidity is priced, the time-series intercept will be jointly equal to zero after controlling for the liquidity factor. Following Nguyen et al (2007), Gu and Huang (2010), and Hwang et al (2010), we use the test developed by Gibbons, Ross, and Shanken (GRS, 1989) to check whether the intercepts are jointly equal to zero. 7 We construct 25 portfolios for each year using Hong Kong stock data.…”

“…They find that liquidity remains an important factor even after controlling for the effects of market, size, bookto-market equity, and momentum. Nguyen et al (2007) examine the role of liquidity on returns after taking into account the effects of the three-moment CAPM, the three-factor Fama-French CAPM, and Pastor and Stambaugh (2003) factors. Their findings support those of Amihud and Mendelson in that liquidity plays an important role in pricing returns even after taking all the factor models into account.…”

Liquidity, Governance and Adverse Selection in Asset Pricing

“…Next, Acharya and Pedersen (2005) enhanced the traditional CAPM by including liquidity risk and showed that the explanatory power of this model is superior. Nguyen, Mishra, Prakash and Ghosh (2007) investigated the ability of the Fama-French three-factor model and the higher moment models to capture liquidity risk. Liquidity is now well established as an important risk factor that captures more than idiosyncratic risks-it captures market-wide systematic risk components.…”