University of Washington Business School - Department of Finance & Business Economics
This paper demonstrates the importance of liquidity for asset pricing. Unique measures of firm-level liquidity, based on fundamental microstructure models, are proposed and estimated using intraday data for the period 1983-2001. An economy-wide liquidity factor is then constructed using these measures. Systematic liquidity risk, rather than the absolute level of liquidity, is shown to be important in explaining cross-sectional variation of expected returns. Applying the framework developed here to the momentum anomaly suggests that profits are associated with liquidity risk, and that there exists possible limits to arbitrage due to low levels of liquidity.