Liquidity Risk and Expected Stock Returns
NBER Working Paper No. 8462
This study investigates whether market-wide liquidity is a state variable important for asset pricing. We find that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Our monthly liquidity measure, an average of individual-stock measures estimated with daily data, relies on the principle that order flow induces greater return reversals when liquidity is lower. Over a 34-year period, the average return on stocks with high sensitivities to liquidity exceeds that for stocks with low sensitivities by 7.5% annually, adjusted for exposures to the market return as well as size, value, and momentum factors.
Published: Pastor, Lubos and Robert F. Stambaugh. "Liquidity Risk And Expected Stock Returns," Journal of Political Economy, 2003, v111(3,Jun), 642-685.