economic recessions) should be viewed much more
negatively(witharesultinghigherexpectedreturn)thanan
asset that is illiquid when the market is liquid. Thus the
liquiditybetaof anasset willreflectthecovariance ofthe
asset’sliquiditywithmarketliquidity.AcharyaandPedersen
estimatethatilliquidstockshaveannualizedrisk premiums
about 1.1 percent higher than liquid stocks, and that 80
percentofthispremiumcanbeexplainedbythecovariance
betweena stock’s illiquidity and overallmarket illiquidity.
PastorandStambaugh(2003)alsoconcludedthatitisnota
stock’s liquidity per se that matters but its relationshipto
overall market liquidity.
25 Overthe34-yearperiodthattheyexaminedstockreturns,
theyconcludedthatstockswhosereturnsaremoresensitive
tomarket liquidityhaveannualreturnsthat are7.5percent
higher than stocks whose returns have low sensitivity to
marketliquidity,afteradjustingforthestandardsize,value,
and momentum factors.
The difficulties associated with modeling liquidity and
arriving at usable models have led many researchers to
considermorepracticalwaysofincorporatingilliquidityinto
expectedreturns. Buildingontheworkdoneonmultifactor
modelsinthe1980sandproxymodelsthe1990s,theylooked
forwaysofmeasuringliquidityandincludingthesemeasures
toexplaindifferencesinstockreturnsoverlongtimeperiods.
Amihud and Mendelson (1989) examined whether adding
bid-askspreadstobetashelpedbetterexplaindifferencesin
returns across stocks in the United States.
26 IntheirsampleofNYSEstocksfrom 1961 to1980,they
concludedthatevery 1 percentincreaseinthebid-askspread
(asapercentofthestockprice)increasedtheannualexpected
returnby0.24to0.26percent.Eleswarapu(1997)confirmed