Scandinavian Working Papers in Economics

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2006/9: Pricing Implications of Shared Variance in Liquidity Measures

Lorán Chollete (), Randi Næs () and Johannes A. Skjeltorp ()
Additional contact information
Lorán Chollete: Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Finance and Management Science, Helleveien 30, N-5045 Bergen, Norway
Randi Næs: Norges Bank, Postal: Norges Bank, Bankplassen 2, P.O.Box 1179 Sentrum, 0107 Oslo , Norway
Johannes A. Skjeltorp: Norges Bank, Postal: NHH , Norges Bank, Bankplassen 2, P.O.Box 1179 Sentrum, 0107 Oslo , Norway

Abstract: Is the effect of liquidity risk on asset prices sensitive to our choice of liquidity proxy? In addressing this fundamental question, we achieve two main results. First, when we estimate factor models on a broad range of liquidity measures we uncover a profound distinction between trade and order based liquidity. Second, although the order based factor provides a better signal of available liquidity, we find that only the factor related to information risk explains expected returns both in a theoretical liquidity-CAPM model and in a linear pricing framework. Our results suggest a surprising fragility of liquidity-based asset pricing.

Keywords: CAPM; Liquidity Risk; Liquidity Factor; Order Based Measure; Trade Based Measure; Information Risk

JEL-codes: G12; G14

41 pages, First version: August 4, 2006. Revised: June 21, 2007.

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