Asymmetric liquidity risks and asset pricing

This paper contributes to the debate about the extent to which liquidity risk affects asset prices. Motivated by evidence on downward liquidity spirals, flights to liquidity and investor perceptions of risk, we develop and test a liquidity-adjusted capital asset pricing model in which the key innovation is separating liquidity risk into asymmetric upside and downside risks. Our model bridges the literature on asset pricing implications of liquidity and the literature on nonlinear pricing kernels. We find strong empirical support for the model in cross-sectional tests. Stocks with high downside liquidity risk command an economically meaningful expected return premium, which is distinct from that of upside liquidity risk. Expected illiquidity is also associated with a return premium. The premiums are robust to permutations of the model and controlling for a wide range of other known factors including the market, size, and value factors, momentum, short-term reversal, and co-skewness. JEL classification: G12