Liquidity and its effect on asset returns

Abstract: With data covering 20 years, we test three different liquidity measures' explanatory power in explaining asset returns on the Swedish stock market, and if an illiquidity premium exists. After establishing whether an illiquidity premium exists or not, we test whether the asset pricing models CAPM and the Fama-French three-factor model can benefit from including a liquidity factor. We use t-tests and regressions to test the liquidity measures and whether our chosen asset pricing models benefit from including a liquidity factor. Our findings do not support the definition of an illiquidity premium for our liquidity measures Return to dollar volume, Turnover rate, and Zero trading days. We apply a common definition of the illiquidity premium, which is that the least liquid portfolio should outperform the most liquid portfolio. We do, however, find that liquidity can to some degree explain asset returns, and when constructing a liquidity factor and including it into our asset pricing models, their explanatory power increases. Therefore, liquidy still might be a variable one should consider when explaining asset returns. Both CAPM and Fama-French three-factor model becomes better when including liquidity, and the result is consistent in our robustness test where we divide our sample into subperiods.