Pricing Implications of Shared Variance in Liquidity Measures

This paper constructs fundamental liquidity measures and investigates the pricing implications of shared variation in a large set of high frequency liquidity measures. Through a common factor analysis we estimate three orthogonal liquidity variables that statistically capture time series variation in market wide liquidity. We uncover three main results. First, we document that not one but two of the common liquidity factors are significantly related to cross-sectional differences in returns. Interestingly, the two factors are related to the time and quantity dimension of liquidity, not the price dimension. Second, and perhaps more striking, we discover substantial heterogeneity in the liquidity factors. In particular, order-based liquidity measures cannot explain return differences while trade-based liquidity measures can explain returns. This heterogeneity is borne out by asset pricing tests, which indicate substantial differences in the pricing of trade and order-based portfolios. Third, there is strong evidence of parameter instability in the pricing of liquidity