Time-Varying Liquidity Risk and the Cross Section of Stock Returns

This paper studies whether stock returns' sensitivities to aggregate liquidity fluctuations and the pricing of liquidity risk vary over time. We find that liquidity betas vary across two distinct states: one with high liquidity betas and the other with low betas. The high liquidity-beta state is short lived and characterized by heavy trade, high volatility, and a wide cross-sectional dispersion in liquidity betas. It also delivers a disproportionately large liquidity risk premium, amounting to more than twice the value premium. Our results are consistent with a model of liquidity risk in which investors face uncertainty about their trading counterparties' preferences. The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org., Oxford University Press.