Scandinavian Working Papers in Economics

Working Papers,
Lund University, Department of Economics

No 2011:24: The components of the illiquidity premium: An empirical analysis of U.S. stocks 1927-2010

Björn Hagströmer (), Birger Nilsson () and Björn Hansson ()
Additional contact information
Björn Hagströmer: School of Business, Postal: Stockholm University, Sweden
Birger Nilsson: Department of Economics, Lund University, Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund, Sweden
Björn Hansson: Department of Economics, Lund University, Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund, Sweden

Abstract: This paper estimates a conditional version of the liquidity adjusted CAPM by Acharya and Pedersen (2005) using NYSE and AMEX data from 1927 to 2010 to study the illiquidity premium and its variation over time. The components of the illiquidity premium is in this model derived as the level of expected illiquidity together with three types of illiquidity risks. We measure illiquidity of individual stocks by the efficient spread proxy developed in Holden (2009) and employ illiquidity sorted portfolios as test assets. The average annual illiquidity premium is estimated to 1.55%, the respective contributions from illiquidity level being 1.15% and from the three different illiquidity risks 0.40%. Results also indicate that commonality risk is the least important component in the illiquidity risk premium, while a component related to the hedging of wealth shocks is the most important. The illiquidity premium varies substantially over time, with peaks in downturns and crises, but with no general tendency to decrease over time.

Keywords: illiquidity level premium; illiquidity risk premium; conditional LCAPM; effective tick

JEL-codes: C22; G11; G12

25 pages, August 19, 2011

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