The predictive performance of liquidity risk

Abstract

This paper assesses the explanatory power of the liquidity-risk-based pricing models relative to the Fama–French three-factor model (FF3) and the extensions to the FF3. We find that the liquidity-augmented capital asset pricing model (LCAPM) performs no worse but generally better than other models considered in describing liquidity risk and a variety of anomaly portfolios. Our finding remains intact relative to the troublesome portfolios related to small, value, and aggressive investment. This study highlights that liquidity risk is not negligible, which is in contrast to some recent findings that the price-impact-based liquidity risk factor contributes little to explain average returns.