Liquidity Augmented Capm

The liquidity-augmented CAPM over 1926 to 1963

Weimin Liu £

Nottingham University Business School (NUBS), The University of Nottingham, Nottingham NG8 1BB, UK

Abstract This paper examines the two-factor model of Liu (2006) using the recent CRSP compilation of daily trading volume data between 1926 and 1962. I find that the liquidity premium is as strong for the early period as for the post 1963-period, and it is the most significant and persistent premium compared with those associated with size, book-to-market, turnover, return-to-volume ratio, and past return. The twofactor model performs well in explaining the cross-section of stock returns. The evidence suggests that the original results of Liu are robust to the earlier period. In addition, liquidity as a firm characteristic lacks significant predictive power beyond liquidity risk. JEL classification: G12; G14 Keywords: Trading continuity; liquidity risk; liquidity premium

I am grateful for comments from Norman Strong, Lubos Pastor, David Newton, and seminar participants at the University of Essex and the University of Nottingham. I would like to express my particular thanks to Michael Brennan from whom I have received very helpful input. £ Tel.: +44 (0)115 846 6018. Email address: weimin.liu@nottingham.ac.uk (Weimin Liu).

Electronic copy available at: http://ssrn.com/abstract=968007

1. Introduction

Examining cross-sectional difference in asset expected returns with respect to liquidity has been a hot topic recently. The consequence of this growing literature is an increased awareness among academics and practitioners of the importance of liquidity in understanding asset price behavior. We can roughly classify the liquidity literature into three categories. One is the search for liquidity proxies. Amihud and Mendelson (1986) suggest the bid-ask spread measure, Datar, Naik, and Radcliffe (1998) use turnover (i.e., the ratio of the number of shares traded to the number of shares outstanding) as an...