Idiosyncratic Volatility of Liquidity and Expected Stock Returns

Ferhat Akbas Will J. Armstrong Ralitsa Petkova , ,

December, 2011

ABSTRACT We show that idiosyncratic liquidity risk is positively priced in the cross-section of stock returns. Our measure of idiosyncratic liquidity volatility is based on a market model for stock liquidity. Idiosyncratic volatility of liquidity is priced in the presence of systematic liquidity risk: the covariance of stock returns with aggregate liquidity, the covariance of stock liquidity with aggregate liquidity, and the covariance of stock liquidity with the market return. Our results are puzzling in light of Acharya and Pedersen (2005) who develop a model in which only systematic liquidity risk aects returns.

We thank Kerry Back and seminar participants at the Bank of Canada, Purdue University, Texas A&M University, University of Georgia, and University of Oklahoma for helpful comments and suggestions. KU School of Business, University of Kansas, Lawrence KS 66049, USA.; E-mail: akbas@ku.edu. Mays Business School, Texas A&M University, College Station TX 77845, USA.; E-mail: warmstrong@mays.tamu.edu. Corresponding author. Krannert School of Management, Purdue University, West Lafayette IN 47906, USA. Tel.: 765 494 4397; E-mail: rpetkova@purdue.edu.

There is increasing evidence that liquidity aects asset returns.

Numerous studies

examine the liquidity characteristics of stocks and show that illiquid assets earn higher expected returns.1 Furthermore, the evidence also shows that the liquidity of individual stocks varies over time. If a stocks liquidity is very volatile this will increase the uncertainty attached to the stock position and limit the investors exibility at the time he chooses to trade.2 For example, an investor who needs to reduce his exposure in a stock may have to sell at re-sale prices or unbalance his portfolio by selling his most liquid securities. In extreme cases, a stocks liquidity may suddenly dry up eliminating the opportunity for the investor to enter or exit the position at all. Part of the variation in a stocks liquidity is systematic since it is driven by factors that aect all stocks, such as variation in market-wide liquidity. The sensitivity to aggregate market liquidity creates commonality in the liquidity variation across stocks and most stocks become more (less) liquid when aggregate market liquidity increases (decreases).3 It seems reasonable that investors might require compensation for being exposed to systematic liquidity variation. Consider, for example, an investor who has experienced a large drop in wealth and must liquidate some assets to raise cash. Since a decline in wealth is likely to occur at times when aggregate liquidity is low, all the assets held by the investor are likely to become less liquid due to commonality. Therefore, the commonality in liquidity is a systematic risk that cannot be diversied away. Since liquidation is costlier when liquidity is low, the investor would require higher expected returns from assets whose liquidity has
See, among others, Amihud and Mendelson (1986, 1989), Brennan and Subrahmanyam (1996), Eleswarapu (1997), Brennan, Chordia and Subrahmanyam (1998), Chalmers and Kadlec (1998), Chordia, Roll and Subrahmanyam (2001), Amihud (2002), Hasbrouck (2009), Chordia, Huh, and Subrahmanyam (2009). 2 Persaud (2003) observes that there is a broad belief among users of nancial liquidity-traders, investors and central bankersthat the principal challenge is not the average level of nancial liquidity, but its variability and uncertainty. 3 The commonality in liquidity has been documented by Huberman and Halka (2001), Chordia, Roll, and Subrahmanyam (2000), and Hasbrouck and Seppi (2001), among others.
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stronger covariance with market liquidity. Acharya and Pedersen (2005) conrm that this type of liquidity risk due to commonality is priced in the cross-section of stock returns. Another part of the variation in individual stock liquidity comes from variation in idiosyncratic sources of liquidity. These include information uncertainty, idiosyncratic

information content of trades (adverse selection), volatility in depth of sources of supply and demand, demand from dierent parties, dealer inventories, and others. Since it is not likely that these idiosyncratic sources of variation always move together across stocks, idiosyncratic variation in liquidity might make some stocks more liquid and others less liquid at a time when the investor needs to raise cash. Therefore, idiosyncratic liquidity variation is a source of risk that could potentially be diversied away. Standard intuition suggests that if investors hold well-diversied portfolios, idiosyncratic liquidity variation should not aect expected returns. In this paper we show, however, that idiosyncratic volatility of liquidity is priced in the cross-section of stock returns. We use a simple model that decomposes individual liquidity into systematic and idiosyncratic components. The volatility of the idiosyncratic component commands a signicant and positive price of risk in the cross-section of stocks. This result suggests that investors require a risk premium for holding stocks with high idiosyncratic variation in liquidity. In this study we consider a stock to be illiquid when trading induces negative price impact. If investors want to sell large amounts in a short period of time, the price impact is of special concern (e.g. Brennan et al. (2011)). This is the case since price impact decreases the potential return from investing in a stock by reducing the price received when the investor attempts to sell the stock. This price impact view of liquidity is theoretically motivated in Kyles (1985) model which predicts that there is a linear relation between net

order ow and price changes. In addition, Brunnermeier and Pedersen (2009) dene liquidity theoretically as the dierence between transaction prices and fundamental values as a result of buying or selling pressure. Therefore, in our empirical analysis we use the price impact of trade based on Amihud (2002) as a measure of liquidity. According to this measure, stocks are considered to be liquid if a large volume of shares can be traded without aecting the price substantially. For each stock, we compute its daily Amihud measures across time. We regress the daily Amihud measures within a month on contemporaneous market liquidity and the market return. The standard deviation of the residuals from this regression proxies for idiosyncratic volatility of liquidity.4 We nd reliable evidence that stocks with high idiosyncratic variability in liquidity command higher expected returns. This nding persists across a wide range of robustness checks, which include standard control variables, exposure to common risk factors, and dierent sub-periods. Furthermore, we show that idiosyncratic volatility of liquidity is priced in the presence of the level of liquidity and systematic liquidity risk. In our empirical analysis we consider three types of systematic liquidity risk. The rst one is related to commonality in liquidity and is measured by the covariance of stock liquidity with aggregate liquidity. The second type is measured by the covariance of stock returns with aggregate market liquidity. Pastor and Stambaugh (2003) observe that market liquidity is an important feature of the investment environment and they show that dierences in expected returns are signicantly related to the sensitivities of returns to uctuations in aggregate liquidity. The third type of systematic liquidity risk is measured by the covariance of stock liquidity with the market return. This risk reects the diculty of selling illiquid stocks during market downturns.
More precisely, the volatility of liquidity is measured as the standard deviation of the residuals scaled by the average level of liquidity. We do this since the mean and standard deviation of liquidity are highly correlated due to the presence of dollar volume in the Amihud liquidity measure.
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Acharya and Pedersen (2005) develop a model that incorporates all three types of systematic liquidity risk. Their model provides a unied theoretical framework that explains previous empirical ndings that return sensitivity to market liquidity is priced (Pastor and Stambaugh (2003)), that average liquidity is priced (Amihud and Mendelson (1986)), and that liquidity comoves with returns and predicts future returns (Amihud (2002), Chordia et al. (2001), Jones, (2002), and Bekaert et al. (2007)). In their model, the expected return of a security is increasing in its expected illiquidity, its market beta, and three betas representing dierent forms of liquidity risk. These liquidity risks are associated with commonality in liquidity with market liquidity, return sensitivity to market liquidity, and liquidity sensitivity to market returns. Other studies also examine the pricing of systematic liquidity risk. Bekaert et al. (2007) study nineteen emerging markets using a model that extends Acharya and Pedersen (2005). They use country-specic and global liquidity factors and show that the price of local liquidity risk is positive and signicant. Sadka (2006) examines the pricing of liquidity risk in a factor model that includes the three Fama-French factors and a liquidity factor, calculated as an average of the stocks permanent market impact coecients. The results show that the liquidity factor is priced, with a positive risk premium. Watanabe and Watanabe (2008) propose that the eect of liquidity on stock returns varies over time across identiable states. They nd that liquidity loadings are higher in states when investors may expect liquidity needs, especially when turnover is abnormally high. In states of high liquidity betas, the price of liquidity risk is higher. Liu (2004) uses a factor-mimicking portfolio for aggregate liquidity. He shows that a model that contains the market return and the tracking portfolio for liquidity performs well in explaining stock returns. Chordia et al. (2001) examine another form of liquidity risk, measured by the total volatility of trading activity. They show that

the level and volatility of trading activity have a negative eect on stock returns. Their ndings are not directly comparable to ours or the studies mentioned above since they focus on the total volatility of trading activity. All the models mentioned above predict that only systematic liquidity risk should aect expected return. Therefore, our nding that the idiosyncratic volatility of liquidity is priced, in addition to systematic liquidity variation, represents a puzzle within the context of these models. If investors hold well-diversied portfolios, idiosyncratic liquidity volatility should not aect expected returns. This is the case since high variation in liquidity implies that some stocks may become more liquid and others less liquid at a time when the investor needs to trade. This suggests that the investors will be able to raise cash by choosing to liquidate the more liquid securities. For example, Brown, Carlin, and Lobo (2010) develop a one-period model in which the investor faces a margin constraint and experiences an urgent need for liquidity. They nd that, for a given portfolio and price impact parameters, the investor optimally sells assets that are more liquid to meet pending obligations. Therefore, in suciently diversied portfolios, idiosyncratic liquidity variance is likely to be diversied away. In contrast, we nd that idiosyncratic liquidity variation signicantly aects expected returns, and the eect is positive. We oer a possible explanation for the positive relation between average returns and idiosyncratic liquidity risk. If an investor faces an immediate liquidity need due to exogenous cash needs, margin calls, dealer inventory rebalancing, forced liquidations, or standard portfolio rebalancing, he needs to unwind his positions in a short period of time. In case of such a liquidity need the investor may not be able to wait for periods of high liquidity to sell the stock, and thus the level of liquidity of the stock on the day the investor closes his position is important. This eect will be reinforced if investors are

subject to borrowing constraints and cannot borrow easily in case of an urgent consumption need (e.g., see Huang (2003)). The higher a stocks idiosyncratic volatility of liquidity, the more likely it is that the stock will be very illiquid at a time when it is traded. Therefore, the investor might end up unwinding his position at a low level of liquidity for the stock, which induces a signicant loss of wealth due to a large price impact of trade. Thus, investors will require compensation for being exposed to this risk. All else equal, a risk-averse investor may be willing to pay a higher price for a stock that has a lower risk of becoming less liquid at the time of trading, i.e., a stock with a low idiosyncratic liquidity variation. In addition, when the investor faces an immediate consumption need, it may not be optimal to sell the more liquid securities to meet his short term obligations. This is the case if the investor expects further liquidity shocks in the future. For example, Scholes (2000) notes, In an unfolding crisis, most market participants respond by liquidating their most liquid investments rst to reduce exposures and to reduce leverage ... However, after the liquidation, the remaining portfolio is most likely unhedged and more illiquid. Without new inows of liquidity, the portfolio becomes even more costly to unwind and manage. Brown, Carlin, and Lobo (2010) develop a model that captures this intuition. They point out that selling the more liquid assets rst will limit the immediate loss in portfolio value. However, the remaining portfolio will be more exposed to adverse conditions in the future. Selling the less liquid assets rst will result in a portfolio that is less exposed to future liquidity shocks. However, this could result in unnecessary loss in portfolio value if the subsequent liquidity shock does not materialize. Brown, Carlin, and Lobo (2010) obtain a theoretical solution for this tradeo and show that if the expected future liquidity shock is suciently large, the investor would prefer to retain more of the assets with low price impact in order to hedge against future conditions. Therefore, when the investor faces an immediate liquidity need

he might end up selling stocks that have become very illiquid at the time of trading due to high volatility in their liquidity. In summary, our paper contributes to the literature by documenting that the positive eect on returns of idiosyncratic volatility of liquidity is dierent from previously documented eects such as the mean level of liquidity and systematic liquidity risk. We conjecture that the volatility of liquidity matters most for investors who may face an immediate liquidity need over a relatively short horizon and are unable to adapt their trading to the state of liquidity of their stocks. For example, a mutual fund manager faced with unexpected investors redemptions will be forced to engage in liquidity-motivated trading. The manager may be forced to liquidate securities that are highly illiquid at the time. Edelen (1999), among others, documents that the common nding of negative return performance at open-end mutual funds could be attributed to the costs of liquidity-motivated trading. Furthermore, the volatility of liquidity is also important for investors who might not be professional traders. For example, a household may have to liquidate its illiquid assets due to consumptions needs. Similarly, a rm may have to liquidate certain assets to undertake a surprise investment opportunity. The rest of the paper is organized as follows. In section I we discuss the benchmark model that denes systematic liquidity risk. Then we describe the construction of our idiosyncratic volatility of liquidity measure and the data sample. Section II documents the main results. Robustness tests are presented in section III, and section IV concludes.

I. Empirical Methods
A. Benchmark Model
In this section we dene a benchmark model for systematic liquidity risk. We will use this model as a starting point to show that idiosyncratic volatility of liquidity is priced in addition to systematic liquidity risk. We use the dynamic overlapping-generations model of Acharya and Pedersen (2005) who study the eects of variations in liquidity on asset prices under risk aversion. The illiquidity cost, ci in the model is dened as the cost of selling security i. Uncertainty about the illiquidity cost is what generates the liquidity risk in the model. When investors are risk averse and illiquidity and dividends are risky, Acharya and Pedersen (2005) show that the conditional expected net return of security i in the unique linear equilibrium is Et (rit+1 cit+1 ) = rf + t Covt (rit+1 cit+1 , RM t+1 CM t+1 ) , V ar(RM t+1 CM t+1 ) (1)

where rit+1 cit+1 is the return of security i net of liquidity cost ci , RM t+1 CM t+1 is the return of the market portfolio net of the aggregate liquidity cost CM , and rf is the risk-free rate. Equivalently, equation (1) can be written as Et (rit+1 rf ) = Et (cit+1 ) +t Covt (cit+1 , CM t+1 ) Covt (rit+1 , RM t+1 ) + t V ar(RM t+1 CM t+1 ) V ar(RM t+1 CM t+1 ) Covt (rit+1 , CM t+1 ) Covt (cit+1 , RM t+1 ) t t . (2) V ar(RM t+1 CM t+1 ) V ar(RM t+1 CM t+1 )

Equation (2) states that the required excess return is the expected relative illiquidity cost, Et (ci ), plus four betas (covariances) times the price of risk . For convenience, we denote
R C C R the four covariance terms above as r , c , r , and c , respectively. As in the standard R CAPM, the model shows that the excess return on an asset increases with market beta r .

The model of Acharya and Pedersen contains three additional betas which represent three dierent types of liquidity risk.
C The rst liquidity beta c is positive for most assets due to commonality in liquidity.

Since investors want to be compensated for holding a security that becomes illiquid when
C the market in general becomes illiquid, the expected excess return increases with c in the C model. The second liquidity beta r measures the sensitivity of asset returns to market-

wide illiquidity. It is usually negative since an increase in market illiquidity implies that asset values will go down (e.g., Amihud (2002)). This liquidity beta has a negative eect on excess returns since investors are willing to accept a lower return on an asset whose return
R is higher in states of high market illiquidity. The third liquidity beta c is also negative for

most stocks (e.g., Acharya and Pedersen (2005) and Chordia et al. (2006)). It has a negative eect on excess returns since investors are willing to accept a lower expected return on a security that is liquid in a down market. The model in equation (2) implies that only systematic liquidity risk commands a risk premium in the cross-section of expected returns. Our objective is to test whether idiosyncratic variation in liquidity is also priced in addition to systematic variation. We are motivated by previous studies that nd that types of idiosyncratic risk are priced in the cross-section of returns. For example, numerous studies have documented that the idiosyncratic volatility of returns is a signicant determinant of average returns.5 Since liquidity aects the level of prices, liquidity volatility can aect asset price volatility itself. Therefore, idiosyncratic volatility of liquidity may aect expected returns through its eect on return volatility. Before we proceed to test whether idiosyncratic volatility of liquidity is priced in the cross-section of returns, we dene the measure of liquidity that we use.
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See, among others, Ang et al. (2006, 2009), Fu (2009).

B. The Main Measure of Liquidity

Liquidity is a stock characteristic that is dicult to dene. Usually, a stock is thought to be liquid if large quantities can be traded in a short period of time without moving the price too much. If an investor faces an immediate need to sell a stock, he may not be able to adapt his trading to the liquidity state of the stock. If he needs to unwind his position in the stock in a short time he might sell at a very unfavorable price due to the high price impact of trade. Therefore, the price impact of trade dimension of liquidity becomes the most relevant part of liquidity. Thus, we use price impact of trade as our main measure of liquidity. Studies that use price impact as a measure of liquidity include Brennan and Subrahmanyam (1996), Bertsimas and Lo (1998), He and Mamayasky (2001), Amihud (2002), Pastor and Stambaugh (2003), Acharya and Pedersen (2005), and Sadka (2006).6 We follow Amihud (2002) and use a measure of liquidity which captures the relation between price impact and order ow. A key benet of using Amihuds (2002) measure is that it can be estimated over a long sample period at relatively high frequencies. Measures of price impact that use intraday data also provide high frequency observations of liquidity. These measures have high precision, but are not available prior to 1988. Since we require a long sample period for our asset-pricing tests, we use Amihuds measure which is available for a longer time period. Hasbrouck (2009) compares price impact measures estimated from daily data and intraday data, and nds that the Amihud (2002) measure is most highly correlated with trade-based measures. For example, he nds that the correlation between Kyles lambda and Amihuds measure is 0.82.7 Similarly, comparing various measures of
The bid-ask spread has also been used as a measure of liquidity, starting with Amihud and Mendelson (1986). However, it is a less useful measure of liquidity for large investors since large blocks of shares usually trade outside the bid-ask spread (see, e.g., Chan and Lakonishok (1995) and Keim and Madhavan (1996)). In addition, Eleswarapu (1997) nds that the bid-ask spread does not predict returns for NYSE/AMEX stocks, but only for NASDAQ stocks. 7 Kyles (1985) lambda is rst estimated by Brennan and Subrahmanyam (1996) using intraday trade and
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liquidity, Goyenko, Holden, and Trzcinka (2009) conclude that Amihuds measure yields signicant results in capturing the price impact of trade. They nd that it is comparable to intraday estimates of price impact such as Kyles lambda.8 Therefore, we use Amihuds ratio as the main liquidity proxy in our study.

C. Constructing Idiosyncratic Volatility of Liquidity

We calculate the daily price impact of order ow, following Amihud (2002)9 : cid = |rid | , dvolid (3)

where rid is the return of stock i on day d and dvolid is the dollar trading volume for stock i on day d.10 The higher the daily price impact of order ow is, the less liquid the stock is on that day. Therefore, Amihuds ratio measures illiquidity. We denote it as c to keep the notation comparable to the model described in section I.A. The mean level of illiquidity for month t is calculated as follows: 1 illiqit = Dit
Dit

d=1

|ridt | , dvolidt

(4)

where Dit is the number of trading days in month t. We use a market model time-series regression for each stock to decompose daily variation in individual stock illiquidity into systematic and idiosyncratic components. More
quote data. Brennan and Subrahmanyam (1996) estimate lambda by regressing trade-by-trade price change on signed transaction size. Lambda measures the price impact of a unit of trade size and, therefore, it is larger for less liquid stocks. Hasbrouck (2009) uses a similar method to estimate Kyles lambda. 8 They also compare Pastor and Stambaughs (2003) gamma and the Amivest liquidity ratio, and conclude that these measures are ineective in capturing price impact. 9 Acharya and Pedersen (2005) also use daily Amihud measures to construct total volatility of liquidity. They use the volatility of liquidity as a sorting variables for portfolios. They do not examine its pricing in the cross-section of stock returns 10 We have also tried adjusting c for ination as cid = dvol|rid | dt , where infdt is an ination-adjustment id inf factor. We obtain similar results.

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specically, using daily data within a month, we regress daily rm-level illiquidity on daily aggregate market illiquidity and the excess market return: cid = b0i + b1i CM d + b1i (RM d rf d ) + eid , (5)

where RM d rf d is the excess market return on day d and CM d is a measure of aggregate market illiquidity on day d. Aggregate illiquidity is computed as an equally-weighted average of the illiquidities of all stocks. This model species two sources of commonality in illiquidity. The rst one, CM , is motivated by Chordia et al. (2000) who show that market-wide liquidity drives variation in the liquidity of all stocks. The second one, RM , is motivated by the observation that liquidity tends to change with the market return (e.g., Hameed et al. (2010)). The standard deviation of the residuals from equation (5), (eid ), measures the variation in individual illiquidity which is not related to movements in aggregate illiquidity or the market return. We use it as a measure of idiosyncratic variation in liquidity.11 The mean level of illiquidity, illiq from equation (4) and the standard deviation of the residuals from equation (5) are highly correlated. In our empirical analysis we control for the mean level of illiquidity and therefore, it is important to have a measure of the volatility of liquidity which is not highly correlated with the mean. Therefore, every month we compute a coecient of variation by dividing the idiosyncratic volatility of liquidity by the mean level of illiquidity:

ivolliqit =

(eid )t . illiqit

(6)

We use the coecient of variation ivolliqit as our measure of the idiosyncratic volatility of
Even though we refer to it as volatility of liquidity, it is actually the volatility of illiquidity since Amihuds ratio measures illiquidity. The higher the volatility of the Amihud ratio within a month, the riskier the stock will be.
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liquidity for stock i in month t. We examine the relation between this variable and average stock returns and show that they are signicantly positively correlated.

D. Data and Descriptive Statistics

Our main data sample consists of NYSE-AMEX common stocks for the period from January 1964 to December 2009.12 Following Avramov, Chordia and Goyal (2006), we exclude stocks with a month-end price of less than one dollar to ensure that our results are not driven by extremely illiquid stocks. We also require that each stock has at least 15 days with trades each month in order to calculate its volatility of liquidity. Stocks with prices higher than one thousand dollars are excluded. Stocks that are included have at least 12 months of past return data from CRSP and sucient data from COMPUSTAT to compute accounting ratios as of December of the previous year. We compute several other stock characteristics in addition to illiquidity and the idiosyncratic volatility of liquidity. The variable denitions are as follows: SIZE is the market value of equity calculated as the number of shares outstanding times the month-end share price; BM is the ratio of book value to market value of equity. Book value is calculated as in Fama and French (2002) and measured at the most recent scal year-end that precedes the calculation date of market value by at least three months.13 We exclude rms with negative book values. RET 12M is the cumulative return from month t-13 to t-2;
We exclude NASDAQ stocks from the analysis for two reasons. First, Atkins and Dyl (1997) argue that the volume of NASDAQ stocks is inated as a result of inter-dealer activities. Second, volume data on NASDAQ stocks is not available prior to November 1982. 13 Book value is dened as total assets minus total liabilities plus balance sheet deferred taxes and investment tax credit minus the book value of preferred stock. Depending on data availability, the book value of preferred stock is based on liquidating value, redemption value, or carrying value, in order of preferences.
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RET 1M is the return in the previous month; IV OL is idiosyncratic return volatility calculated as the standard deviation of the residuals from the Fama-French (1993) model, following Ang, Hodrick, Xing, and Zhang (2006). We require at least 15 days of return data to compute IV OL. SKEW is the monthly skewness of daily returns; Cov(r, c) is the covariance between daily stock returns and daily stock illiquidity over month t. This variable is motivated by previous studies that show that liquidity comoves with returns (e.g., Amihud (2002)). T URN is the turnover ratio measured as the number of shares traded divided by the number of shares outstanding in month t.14 We also compute several measures of systematic liquidity risk motivated by the model of Acharya and Pedersen (2005). First, using daily data within a month, we regress rm-level illiquidity on changes in market illiquidity and the excess market return:
R C cid = ai + ci CM d + ci (RM d rf d ) + uid .

(7)

Then, using daily data within a month, we regress rm-level excess returns on changes in market illiquidity and the excess market return:
C R rid rf d = i + ri CM d + ri (RM d rf d ) + vid .

(8)

The two slope coecients from equation (7) and the rst slope coecient from (8) are used as measures of systematic liquidity risk. The second slope coecient from (8) is a
Our results are robust to including dollar volume among the set of control variables. However, we exclude dollar volume from the reported results since it is highly correlated with both illiq and SIZE.
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measure of market beta. Note that the four betas dened above are very similar to the ones in model (2) discussed previously. The dierence between the two sets of betas is that the ones in model (2) are univariate, while the ones that we estimate are not. Acharya and Pedersen (2005) observe that there is a strong multicollinearity among their estimates of the three univariate liquidity betas from model (2). Using multivariate regressions as in (7) and (8) alleviates the multicollinearity problem to an extent. In addition, the intuition behind the interpretation of the liquidity betas is preserved in the multivariate regressions. We also note that using changes in aggregate market illiquidity in (7) and (8) allows for capturing the eects of lagged values of illiquidity. In our analysis, we match stock returns in month t to idiosyncratic volatility of liquidity and other stock characteristics in month t 1. However, in order to avoid potential

microstructure biases and account for return autocorrelations, we measure stock returns as the cumulative return over a 22-day trading period that begins a week after the various stock characteristics are measured. Skipping a week between measuring stock characteristics and future returns also allows us to use the most recent information about the stocks. This is important since we want to capture the dimension of liquidity related to short-term variability in trading costs. In addition, skipping a week assures that there is no overlap between the returns used as dependent variables and the returns used to derive our liquidity measures. Since liquidity varies over time, skipping a longer time interval might result in loss of information relevant for future returns. However, our results are robust to skipping a month and matching stock returns in month t to stock characteristics in month t 2. Panel A of Table I presents time-series averages of monthly cross-sectional statistics for all stocks. There are on average 1,635 rms each month and the total number of observations is 902,308. Our sample of rms exhibits signicant variation in market capitalization and the

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mean rm size is $2.28 billion. SIZE, BM, and T URN exhibit considerable skewness. In the empirical analysis we apply logarithmic transformations to these variables. Therefore, when we write SIZE, BM, or T URN we are referring to the natural logarithm of the variable. In Panel B of Table I we present time-series averages of monthly cross-sectional Spearman (above diagonal) and Pearson (below diagonal) correlations. The Spearman correlation between SIZE and illiq is -0.94 which is in line with the evidence that smaller rms are less liquid. We utilize various regression specications in our empirical analysis to ensure that the results are not contaminated by this high correlation. The correlation between ivolliq and illiq is positive (0.48) and at a moderate level compared to the correlation between SD(cidt ) and illiq (0.93). In addition, since we use both illiq and ivolliq in our multivariate regressions, the concern that part of the eect of ivolliq on future returns might be due to the correlation of illiq with other variables should be alleviated. Finally, the correlation between IV OL and ivolliq is 0.10, indicating that these two variables do not capture the same eect even though they both depend on stock returns.

II. Main Results

A. Portfolio Approach
We begin the analysis using a portfolio approach where we assign stocks to portfolios based on idiosyncratic volatility of liquidity, ivolliq, and other rm characteristics such as size, illiquidity, momentum, and book-to-market. This is a standard approach, pioneered by Jegadeesh and Titman (1993), which reduces the variability in returns. Each month, we assign stocks into 3 categories based on various rm characteristics. Then we further sort stocks into quintiles based on ivolliq. All stocks are held for a month after skipping a week 16

after portfolio formation. Monthly portfolio returns are calculated as equally-weighted or value-weighted averages of the returns of all stocks in the portfolio. Table II present the average returns of portfolios sorted by ivolliq alone and by characteristics and ivolliq. The rst panel contains the results for the univariate sort on ivolliq using both equal- and value-weighted returns. According to the results, as ivolliq increases the average returns also increase. The dierence between the highest and lowest ivolliq quintiles (P 5-P 1) is 31 (25) basis points per month for equally-weighted (valueweighted) returns. The dierence is signicant with a t-statistic of 2.82 (2.73). We also calculate the abnormal returns of the high-minus-low volatility of liquidity strategy (P 5-P 1) using the Fama-French (1993) model augmented with the momentum factor (FF4). The FF4 alpha is 31 basis points and signicant at the 1% level. Similar results hold for valueweighted returns. In untabulated results we also use the Fama-French (1993) 3-factor model (FF3) and the FF3 model augmented with momentum and aggregate liquidity. The results are qualitatively identical.15 In the second panel of Table II, we rst sort stocks into three groups, S1, S2, and S3, based on SIZE, where S1 represents small stocks and S3 represent large stocks. We then sort stocks independently into quintiles based on ivolliq. The intersection of the two sorts creates 15 portfolios which are held for a month after skipping a week after portfolio formation. The results show that the dierence between the extreme ivolliq quintiles, P 5 and P 1, decreases as rm size increases. While the dierence between P 5 and P 1 for small stocks is 32 basis points per month and signicant, it decreases to an insignicant 7 basis
The aggregate liquidity factor is constructed using 9 equally-weighted portfolios sorted on size and illiquidity. Every month, we sort stocks into 3 groups (Small, Medium, and Big) according to their endof-previous-month market capitalization. Then we further sort stocks into three groups (High, Medium, and Low) according to their average monthly Amihud illiquidity. Each portfolio is rebalanced monthly. The liquidity factor is the average return on three high illiquidity portfolios minus the average return on three low illiquidity portfolios: ILL = 1/3(HighSmall +HighM edium+HighBig)1/3(LowSmall +LowM edium+ LowBig).
15

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points per month for large stocks. However, the positive relation between the volatility of liquidity and returns is not conned to the smallest size group, it is also present among medium cap stocks. The FF4 alpha of the P 5-P 1 strategy is 42 basis points per month for small stocks. Overall, the results suggest that the volatility of liquidity eect is strongest among small stocks. In the remainder of Table II, we perform additional double-sorts using control variables that have been shown to aect returns: illiquidity (illiq), momentum (RET 12M), book-tomarket (BM), and idiosyncratic volatility of returns (IV OL). The result suggest that the average return of the high-minus-low volatility of liquidity strategy (P 5-P 1) is higher for less liquid stocks (ILL3), value stocks (BM3), and stocks with higher idiosyncratic return volatility (IV 3). While past performance over the previous 12 months does not seem to be related to the volatility of liquidity when we use raw returns, the eect appears to be more pronounced among winners when we use the Fama-French model augmented with momentum. Overall, the portfolio approach suggests that the positive relation between idiosyncratic volatility of liquidity and average returns is a separate eect which is dierent than the well-documented size, illiquidity, momentum, book-to-market, and idiosyncratic volatility of return eects. In addition, the ivolliq eect does not seem to be concentrated only among a small portion of the sample of stocks. In untabulated tables, we also use monthly turnover, monthly dollar volume, and contemporaneous monthly returns, and the ivolliq eect is robust to controlling for these additional variables.

18

B. Regression Approach
In this section we extend the portfolio analysis from before by performing cross-sectional regressions. These regressions allow us to control for various other stock characteristics that may potentially aect the relation between idiosyncratic volatility of liquidity and returns. More precisely, we use Fama-MacBeth (1973) regressions in which the dependent variables are excess stocks returns. We adjust the Fama-MacBeth t-statistics for heteroskedasticity and autocorrelation of up to 8 lags. Asparouhova et al. (2010) show that microstructureinduced noise in prices can lead to biases in empirical asset pricing tests. Following their recommendations, we correct for this bias by estimating all regressions using weighted least squares where the weights are based on past month gross returns. When we use the Asparouhova et al. (2010) adjustment, we exclude the variable RET 1M from the analysis. However, our results are similar if we use ordinary least squares and include RET 1M in the regressions. We use two specications for the independent variables. In the rst one, we transform the independent variables into percentile ranks and then standardize the ranks with values between zero and one. This rank transformation has two advantages: it makes the coecient interpretation more intuitive and comparable across variables, and it minimizes the eect of outlier observations. In the second specication, we use the real values of the independent variables. The benchmark model we examine is:
R C C R rit+1 rit+1 = 0 + 1 illiqit + 2 rit + 3 cit + 4 rit + 5 cit + it+1 .

(9)

This model is interesting since it corresponds to the empirical implementation of Acharya and Pedersen (2005). While they test their model on liquidity-sorted portfolios, we use the 19

cross-section of individual stocks. In addition, Acharya and Pedersen use full-sample liquidity betas, while we use liquidity betas estimated with short-window regressions of daily data within each month. The results from estimating regression (9) are presented in Panel A of Table III, Columns 1 and 4. When we use the ranks of the independent variables in Column 1, the level of illiquidity illiq is positively related to average returns, but the relation is not signicant. This result is consistent with the ndings of Acharya and Pedersen (2005). Among the three liquidity betas, the one that measures the covariance between an assets illiquidity and the market return is signicantly negatively priced. This is also in line with the results in Acharya and Pedersen. None of the other betas in the model are signicantly priced.
R When we use the real values of the independent variables in Column 4, the signicance of c

disappears. A possible explanation for this is the fact that the cross-sectional distribution of
R c exhibits considerable skewness and the presence of outliers might inuence the results.

The only risk factors in Acharya and Pedersen are the market return and market liquidity. In order to take into account the exposure of asset returns to other risk factors that have been shown to aect returns, we also look at risk-adjusted excess returns as dependent variables. The risk-adjustment is based on the Fama-French model augmented with a momentum factor following Brennan, Chordia, and Subrahmanyam (1998). The factor loadings with respect to the risk model are estimated using 60-month rolling windows.16 The results for model (9) using risk-adjusted returns are presented in Panel B of Table III, Columns 1 and 4. The results are largely consistent with the ones reported in Panel A. When ranked independent variables are used, the beta that measures commonality in liquidity also becomes signicant. Overall, the results from estimating model (9) suggest
16 We achieve similar results if we use Dimson (1979) betas with one lag. We also use the Fama-French three-factor model to adjust for risk and obtain similar results.

20

that at least one type of systematic liquidity risk is priced in the cross-section of stocks. Next, we directly test whether idiosyncratic volatility of liquidity, ivolliq, is priced in the presence of systematic liquidity risk. We examine the following specication:

R C C R rit+1 rit+1 = 0 +1 illiqit + 2 rit + 3 cit + 4 rit + 5 cit

+6 Covt (rit+1 , cit+1 ) + 7 IV OLit + 8 ivolliqit + it+1 .

(10)

We include the variable Cov(r, illiq) since previous studies have shown that returns and liquidity tend to move together (e.g., Amihud (2002)). In addition, we include the

idiosyncratic volatility of returns, IV OL to account for the fact that the measure of liquidity depends on returns. If systematic liquidity risk is the only part of total liquidity variation that aects returns, then the coecient 8 should be equal to zero. The results from estimating (10) are presented in Panel A of table III, Columns 2 and 5. When the independent variables are ranked in Column 2, the null hypothesis that 8 = 0 is rejected. The coecient in front of ivolliq is 0.22 implying that an increase in idiosyncratic volatility of liquidity from the 1st to the 99th percentile leads to an increase of 22 basis points per month in expected returns. The level of illiquidity and idiosyncratic return volatility are also signicantly priced. Systematic liquidity risk, as measured by the covariance between individual liquidity and the market return, is also signicantly related to returns. Its price of risk is -0.20. Therefore, the price of risk for idiosyncratic liquidity risk (0.22) is of a similar magnitude as the price of systematic liquidity risk. The market beta of the stocks is also signicantly priced. Similar conclusions hold in Column 5 in which the real values of the independent variables are used. Under additional risk-adjustment, in Panel B of Table III, Columns 2 and 5, the 21

idiosyncratic volatility of liquidity remains signicantly positively correlated with expected returns. Note that its price of risk in Column 2 of Panel B, 0.21, is very close to the one reported in Panel A where no further risk-adjustment is used. Therefore, it is not likely that our measure of idiosyncratic liquidity risk is simply a proxy for assets exposure to the Fama-French and momentum factors. To test the robustness of these results, we introduce further control variables in the crosssectional Fama-MacBeth regression (10). These variables are stock-specic characteristics described in Section I.D. The results are presented in Panel A of Table III, Columns 3 and 6. When we use the ranks of the independent variables, the price of idiosyncratic volatility risk is still positive and signicant. Its magnitude increases to 27 basis points per month. Idiosyncratic return volatility and market beta are also signicant, and only one type of
R systematic liquidity risk is priced, c . Among the other stock characteristics, book-to-

market, past returns, and skewness have signicant coecients. The illiquidity level, illiq, is not signicant in Column 3 of Panel A. This lack of signicance may be due to a multicollinearity problem generated by the high correlation between illiq and SIZE. In untabulated results, we exclude SIZE from the model and the coecient on illiq becomes signicantly positive. When we exclude illiq instead,

the coecient on SIZE is negative and signicant. The relation between returns and idiosyncratic liquidity risk is not aected by these modications. Idiosyncratic liquidity risk is signicantly positively priced when we use the real value of the independent variables in Column 5 of Panel A, and risk-adjusted returns in Columns 3 and 5 of Panel B. Overall, the results in Table III suggest that idiosyncratic volatility of liquidity, ivolliq is signicantly positively related to expected returns. This relation persists over and

22

above the positive correlation between the level of illiquidity and returns, and the relation between systematic liquidity risk and returns. The results imply that investors want to be compensated for holding stocks with high idiosyncratic liquidity variation. This might be the case since it is not always possible for investors to time their trades according to the liquidity state of their stocks.

C. Regression Approach within Size and Illiquidity Groups

As mentioned earlier, the high correlation between size and illiquidity may cause potential multicollinearity problems and bias our results. In this section we perform additional tests to ensure that the main results are not driven by this correlation. Every month we sort stocks into three groups based on size and run Fama-MacBeth regressions within each size group. This way we control for size, allowing illiquidity to vary within each size group. For the sake of brevity we report the results using the ranks of the independent variables. The results using the real values of the independent variables are similar and they are available upon request. In Panel A of Table IV, we report Fama-MacBeth regressions within each size category, with excess returns as the dependent variables. We examine the specication that includes all control variables. The results show that the positive relation between ivolliq and returns is stronger among small stocks. The price of ivolliq risk in the small category is 0.48, implying that an increase in ivolliq from the 1st to the 99th percentile leads to an increase in expected returns of 48 basis points per month. Idiosyncratic liquidity risk is signicantly positively related to average returns for medium stocks as well. The relation is not signicant for large stocks. A possible explanation for this nding might be that smaller stocks have low average levels of liquidity and therefore, a high volatility of the liquidity distribution implies that

23

investors in illiquid stocks may face even lower levels of liquidity at a point when they need to trade. Larger stocks, on the other hand, may expose investors to this risk to a lesser extent since their liquidity distributions have higher means. Panel A of Table IV also shows that the level of illiquidity is signicant and positive in the small and medium size groups. The illiquidity eect is stronger for smaller stocks. Systematic liquidity risk does not appear to be priced. The only two stock characteristics that are systematically priced across all categories of stocks are book-to-market and past returns. In Panel B of Table IV, the Fama-MacBeth regressions within each size category are performed using risk-adjusted returns. For small stocks, the coecient on ivolliq is positive and signicant. Its magnitude decreases to 0.35. The signicance level of ivolliq decreases as size increases, but it remains positive among the largest stocks. Overall, the results suggest that, after controlling for the size eect, both the mean and the second moment of illiquidity are positively related to expected stock returns. Therefore, it is not likely that our previous ndings are driven by the high multicollinearity between size and illiquidity.

D. Interpretation of the Positive Price of Risk for ivolliq

In the context of existing models about liquidity risk, the pricing of idiosyncratic liquidity variation presents a puzzle. If investors hold well-diversied portfolios, idiosyncratic liquidity volatility should not aect expected returns. This is the case since high variation in liquidity implies that some stocks may become more liquid and others less liquid at a time when the investor needs to raise cash. This suggests that the investors will be able to raise cash by choosing to liquidate the more liquid securities. Therefore, in suciently diversied portfolios, idiosyncratic liquidity variance is likely to be diversied away.

24

However, several studies document that investors might not be as well-diversied as theory would suggest. For example, Barber and Odean (2000) report that a typical individual investor holds a portfolio with only four stocks. Goetzmann and Kumar (2008) analyze the diversication choices of more than 60,000 individual investors at a large U.S. discount brokerage house during a six-year period (1991 to 1996). They show that more than 25% of the investor portfolios contain only one stock, over half of the investor portfolios contain no more than three stocks, and less than 10% of the investor portfolios contain more than 10 stocks. Additionally, using data from the Survey of Consumer Finances, Polkovnichenko (2005) provides evidence of under-diversication among U.S. households. If investors are not well-diversied, idiosyncratic volatility of liquidity might become important. If an investor faces an immediate liquidity need due to exogenous cash

needs, margin calls, dealer inventory rebalancing, forced liquidations, or standard portfolio rebalancing, he needs to unwind his positions in a short period of time. In case of such a liquidity need the investor may not be able to wait for periods of high liquidity to sell his stock, and thus the level of liquidity of the stock on the day the investor closes his position is important. This eect will be reinforced if investors are subject to borrowing constraints and cannot borrow easily in case of an urgent consumption need (e.g., see Huang (2003)). The higher a stocks idiosyncratic volatility of liquidity, the more likely it is that the stock will be very illiquid at a time when it is traded. Therefore, the investor might end up unwinding his position at a low level of liquidity for the stock, which induces a signicant loss of wealth due to a large price impact of trade. Thus, investors will require a compensation for being exposed to this risk. All else equal, a risk-averse investor may be willing to pay a higher price for a stock that has a lower risk of becoming less liquid at the time of trading, i.e., a stock with a low idiosyncratic liquidity variation.

25

Even if investors hold well-diversied portfolios, idiosyncratic volatility of liquidity may become important. When the investor faces an immediate consumption need, it may not be optimal to sell the more liquid securities to meet his short term obligations. This is the case if the investor expects further liquidity shocks in the future. Brown, Carlin, and Lobo (2010) point out that selling the more liquid assets rst will limit the immediate loss in portfolio value. However, the remaining portfolio will be more exposed to adverse conditions in the future. Selling the less liquid assets rst will result in a portfolio that is less exposed to future liquidity shocks. However, this could result in unnecessary loss in portfolio value if the subsequent liquidity shock does not materialize. Brown, Carlin, and Lobo (2010) obtain a theoretical solution for this tradeo and show that if the expected future liquidity shock is suciently large, the investor would prefer to retain more of the assets with low price impact in order to hedge against future conditions. Therefore, the investor might end up selling stocks that become very illiquid at the time of trading due to high volatility in their liquidity.

III. Robustness Tests

A. Alternative Measurement Periods for ivolliq and illiq
So far our results are based on idiosyncratic volatility of liquidity measured using daily data within a month. However, since the Amihud ratio includes returns, it is possible that our measure of ivolliq captures short-term return autocorrelations that cannot be adjusted for with our control variables. In addition, it might be possible to obtain more precise estimates of idiosyncratic liquidity variation by using a larger sample of daily Amihud ratios. Therefore, in this section we investigate whether our results are robust to alternative measurement periods for our key variable, ivolliq. Instead of using only one month of daily data, we use 26

three and six months of daily Amihud ratios to compute the ivolliq measure. The measure in each case is denoted as ivolliq3M and ivolliq6M, respectively. Table V presents the results using the regression specication that includes the full set of control variables. In Panel A of Table V, using excess returns, the coecient on ivolliq3M is signicantly positive. Its magnitude is higher than the magnitude of the coecient in front of ivolliq in Panel A of Table III, Column 3. When the ivolliq6M measure is used, the price of risk for idiosyncratic volatility of liquidity increases even further to 0.37. These results suggest that the attenuation bias in the estimation of the ivolliq price of risk is smaller when the measure of idiosyncratic liquidity risk is based on more observations and is, therefore, more precise. The results in Panel A of Table V also show that the covariance between individual liquidity and the market return is signicantly priced. So is market beta. The other stock characteristics consistently related to returns are idiosyncratic return volatility, book-tomarket, past returns, and skewness. Similar results hold for risk-adjusted returns. Since the individual illiquidity measure for each stock is also estimated from daily data, the volatility of liquidity might capture the imprecision in estimating the mean level of illiquidity. Therefore, we use an alternative measure of illiquidity which is more precisely estimated to test the robustness of our results. Namely, for each stock we compute its illiquidity by using daily Amihud ratios within the last one year. This measure is denoted by illiq1Y . Our objective is to test whether idiosyncratic volatility of liquidity, ivolliq, is still signicant in the presence of illiq1Y . Table VI presents the results using the full set of control variables. When the ranks of the independent variables are used, the coecient in front of illiq1Y is signicantly positive. This is in contrast to column 3 in Table III in which illiq is not signicantly priced. In both cases, the idiosyncratic volatility of liquidity is

27

signicantly positively priced and the magnitude of the ivolliq coecient is similar. Similar results hold for the real values of the independent variables and for risk-adjusted returns. Therefore, using a more precise measure of illiquidity aects the pricing of the mean level of illiquidity. However, the pricing of idiosyncratic volatility of liquidity is not aected. Therefore, the eect of ivolliq on expected returns seems to be dierent than the eect of the mean level of illiquidity.

B. Expected Idiosyncratic Volatility of Liquidity

We are interested in the relation between expected returns and ex-ante idiosyncratic volatility of liquidity. However, it is not straightforward to test this relation empirically. Our analysis so far uses lagged idiosyncratic volatility of liquidity as a proxy for the exante variable. If the volatility of liquidity is time-varying, lagged volatility of liquidity alone may not adequately forecast expected volatility of liquidity. Therefore, we estimate a crosssectional model of expected idiosyncratic volatility of liquidity that uses additional predictive variables. Specically, we run a cross-sectional regression of ivolliq, measured over the same holding period as returns, on rm characteristics measured at the end of the previous month. In the cross-sectional regressions we use two lags of ivolliq, SIZE, BM, IV OL, RET 1M, RET 12M, illiq, and T URN. Then we use the tted values of ivolliq from the cross-sectional regressions as independent variables in the subsequent Fama-MacBeth regressions. The results are presented in Table VII. The predicted value of ivolliq, F ivolliq, is signicantly positively related to average returns in all specications. Therefore, our main results are robust to this alternative estimate of the volatility of liquidity.

28

C. Alternative Specication of Residual Liquidity

So far we calculate idiosyncratic volatility of liquidity using the residuals of a model that includes aggregate liquidity and the market return. However, if variation in a stocks liquidity is related to factors missing from the model, such as HML and SMB, then our results might capture liquidity covariance with these additional factors rather than idiosyncratic volatility of liquidity. To address this issue, we include the Fama-French factors HML and SMB in the model in equation (5) and estimate ivolliq accordingly. In untabulated results, we also add the momentum factor and obtain similar results. The results are presented in table VIII. The coecient on ivolliq is signicant and positive in all specications. In addition, its magnitude is almost identical to the ones reported in Table III. Overall, the results suggest that using this alternative specication in calculating ivolliq does not aect the conclusion of our tests.

D. Volatility of Liquidity Eect across Business Cycles

In this section, we split the sample into good and bad states of the business cycle. The motivation for doing this comes from recent theoretical research that relates crisis periods to declines in asset liquidity. Several models predict that sudden liquidity dry-ups may occur due to demand eects such as market participants engaging in panic selling, supply eects such as nancial intermediaries not being able to provide liquidity, or both.17 These models predict that the demand for liquidity increases in bad times as investors liquidate their positions across many assets. At the same time, the supply of liquidity decreases in bad times as liquidity providers hit their funding constraints. In addition, borrowing constraints are tighter in bad times. Investors, who cannot borrow easily in case of an emergency
17 See Gromb and Vayanos (2002), Morris and Shin (2004), Vayanos (2004), Garleanu and Pedersen (2007), and Brunnermeier and Pedersen (2009), among others.

29

consumption need, would have to liquidate their positions. As a result, the uncertainty associated with an assets liquidity is likely to increase around crisis periods and become a stronger concern for investors. Therefore, we conjecture that the idiosyncratic volatility of liquidity eect will be stronger during bad economic times. We use the growth rate of industrial production as an indicator of good or bad economic times. The advantage of this variable is that it is a contemporaneous indicator of the business cycle. Data on the level of industrial production comes from the website of the Federal Reserve Bank of St. Louis. Industrial production growth (IND) is dened as the rst dierence in the log of industrial production. To capture crisis periods, we split the sample into two parts: one corresponding to the 10% lowest observations of IND (bad times), the other corresponding to the rest of the observations. We compute the average return of the equally-weighted high-minus-low ivolliq strategy (P 5-P 1) within each subsample. Untabulated results show that the average P 5-P 1 return is 1.38% per month in bad times and 0.19% per month the rest of the time. The dierence between the two is statistically signicant. If we dene bad times as the 25% lowest observations of IND, the average P 5-P 1 return is 0.78% in bad times and 0.19% the rest of the time. The results are similar when we use risk-adjusted returns. Therefore, the results suggest that the expected return premium for stocks with high ivolliq is higher in bad times and increases with the severity of the crisis period.18

E. Additional Robustness Checks

In this section we address some remaining concerns about the main results. First, since our ndings are stronger among small stocks, it might be the case that the results are
18 We obtain similar results by using the default premium as an indicator of good/bad times. The default premium is dened as the spread in yields between a BAA and a AAA bond. The default premium is directly related to the tightness of borrowing constraints.

30

driven by the January eect documented by Keim (1983) (see also Tinic and West (1986), Eleswarapu and Reinganum (1993), and Amihud (2002)). In separate regressions and sorting analysis we control for the January eect and nd similar results. Second, the idiosyncratic volatility of liquidity measure ivolliq might capture an interaction eect between past returns and trading volume. For example, Cooper (1999) and Lee and Swaminathan (2001) document that return continuations accentuate with volume, while Avramov et al. (2006) show that the short-term return reversals accentuate with volume. Accordingly, we include an interaction term between trading volume and past returns and trading volume and contemporaneous returns in the Fama-MacBeth regressions. We nd that the coecient on ivolliq remains positive and signicant. Third, since Amihuds measure of illiquidity includes the absolute value of the return in the numerator, the volatility of this measure might be correlated with the kurtosis of stock returns. When we include kurtosis in our analysis the coecient on ivolliq is still signicant and positive. Finally, to ensure that our results are not driven by a non-linear relation between illiquidity and future returns, we include illiq-squared in the regressions and nd similar results.

IV. Conclusion
In this paper we nd that the idiosyncratic volatility of liquidity is positively related to future returns. The positive correlation between idiosyncratic liquidity risk and expected returns suggests that risk averse investors require a risk premium for holding stocks that have high idiosyncratic variation in liquidity. Our results are robust to various control variables, systematic liquidity risk, and dierent sub-periods. Higher variation in liquidity implies that

31

a stock may become illiquid with higher probability at a time when it is traded. This is important for investors who may face an immediate liquidity need due to exogenous cash needs, margin calls, dealer inventory rebalancing, or forced liquidations. In case of such liquidations, the investor may not be able to time the market by waiting for periods of high liquidity and thus, the level of liquidity on the day of the liquidity need is important. Our results are puzzling in light of recent models that suggest that only systematic liquidity risk is priced in the cross-section of stock returns. Idiosyncratic liquidity risk may proxy for an omitted systematic source of liquidity risk. Additional work is necessary to identify such a source. Alternatively, the pricing of idiosyncratic liquidity volatility may indicate that not all investors are well-diversied. Finally, future theoretical work might identify a mechanism that allows for the pricing of idiosyncratic liquidity risk.

32

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Polkovnichenko, Valery, 2005, Household portfolio diversication: A case for rankdependent preferences, Review of Financial Studies 18, 1467-1502. Sadka, Ronnie, 2006, Momentum and post-earnings announcement drift anomalies: The role of liquidity risk, Journal of Financial Economics 80, 309-349. Tinic, S.M. and R. R. West, 1986, Risk, return and equilibrium: a revisit, Journal of Political Economy 94, 126-147. Vayanos, Dimitri, 2004, Flight to quality, ight to liquidity and the pricing of risk, NBER working paper. Watanabe, Akiko and Masahiro Watanabe, 2008, Time-varying liquidity risk and the crosssection of stock returns, Review of Financial Studies 21, 2449-2486.

36

Table I: Summary Statistics

This table presents time-series averages of cross-sectional summary statistics (Panel A) and monthly cross-sectional correlations (Panel B) for various stock characteristics. The sample consists of common stocks listed on AMEX and NYSE from January 1964 to December 2010. illiq is the Amihud measure of illiquidity, ivolliq is the coecient of variation of liquidity calculated as standard deviation of residual liquidity, obtained by regressing daily stock illiquidity on daily market illiquidity and daily market return over a month, normalized by mean level of liquidity, SIZE is end-of-month price times shares outstanding (in billion dollars), BM is the book-to-market ratio, IV OL is the standard deviation of the residuals from the Fama-French model, T U RN is the turnover ratio measured by the number of shares traded divided by the number of shares outstanding, SKEW is the monthly skewness of daily returns, RET 12M is the cumulative return over the past twelve months, RET 1M is the
R C return during the previous month. c is the coecient estimate RM d rf d and c is the coecient estimate on CM d R obtained by regressing daily rm-level illiquidity on daily excess market return and daily change in market illiquidity. r is the C coecient estimate on RM d and r is the coecient estimate on CM d obtained by regressing daily rm-level excess return on

daily excess market return and daily change in market illiquidity. COV (r, c) is the covariance between stock level daily return and daily illiquidity over a month. Panel In Panel B, we apply log transformations to SIZE, BM , and T U RN . Spearman correlations are reported above the diagonal and Pearson correlations are reported below the diagonal. A: Descriptive Statistics MEAN ivolliq illiq SIZE BM T U RN IV OL SKEW RET 1M RET 12M R c C c R r C r COV (r, c) 1.009 1.551 2.277 0.912 0.710 0.020 0.264 0.014 0.166 1.858 0.470 0.859 0.000 -0.003 MEDIAN 0.926 0.173 0.404 0.725 0.512 0.017 0.228 0.006 0.096 -0.060 0.004 0.779 0.000 0.000 STD 0.36 5.92 7.94 0.93 0.80 0.01 0.87 0.12 0.49 378 9.01 1.07 0.03 0.28 P5 0.61 0.01 0.02 0.18 0.09 0.01 -1.05 -0.14 -0.39 -102 -1.20 -0.63 -0.04 -0.03 P95 1.70 6.78 9.01 2.19 1.94 0.04 1.71 0.19 0.93 102 1.91 2.63 0.04 0.02
C c R r C r COV (r, c)

B: Cross-Sectional Pearson (lower diag.) and Spearman (upper diag.) Correlations

R ivolliq illiq SIZE BM T U RN IV OL SKEW RET 12M RET 1M c

ivolliq illiq SIZE BM T U RN IV OL SKEW RET 12M RET 1M R c C c R r C r COV (r, c)

1 0.27 -0.42 0.16 -0.24 0.15 0.04 -0.09 0.02 0.01 0.12 -0.19 -0.01 -0.03

0.48 1 -0.38 0.14 -0.19 0.38 0.02 -0.11 0.00 0.04 0.52 -0.08 -0.01 -0.09

-0.43 -0.94 1 -0.30 0.13 -0.49 -0.08 0.09 0.02 -0.01 -0.10 0.11 0.00 0.03

0.19 0.31 -0.32 1 -0.15 0.07 -0.02 -0.33 -0.10 0.00 0.04 -0.10 0.01 -0.01

-0.25 -0.37 0.14 -0.15 1 0.23 0.06 0.14 0.12 0.00 -0.05 0.28 0.01 0.00

0.10 0.48 -0.53 0.06 0.27 1 0.19 -0.08 0.17 0.02 0.14 0.11 0.00 -0.04

0.03 0.07 -0.08 -0.02 0.07 0.18 1 -0.02 0.34 0.00 0.01 0.04 0.00 0.00

-0.11 -0.19 0.16 -0.34 0.09 -0.15 -0.03 1 0.01 0.00 -0.04 0.06 -0.01 0.01

-0.02 -0.06 0.06 -0.11 0.09 0.04 0.31 0.03 1 0.01 0.01 0.03 -0.01 0.00

0.00 -0.03 0.03 -0.01 -0.01 -0.03 0.05 0.00 0.10 1 0.07 -0.01 0.00 0.05

0.03 0.08 -0.07 0.02 -0.02 0.05 0.01 -0.02 0.00 0.05 1 -0.02 -0.01 -0.06

-0.23 -0.16 0.13 -0.11 0.30 0.17 0.04 0.04 0.04 -0.03 0.00 1 0.05 0.00

-0.01 0.00 0.00 0.01 0.01 0.01 0.00 -0.01 -0.01 0.01 0.00 0.05 1 0.06

-0.06 -0.10 0.11 -0.04 -0.01 -0.07 0.15 0.00 0.23 0.21 -0.01 0.00 0.02 1

37

Table II: Average Portfolio Returns

This table presents average returns (in % form) for various portfolios. The rst set of portfolios involves a single sort on the volatility of liquidity, ivolliq. The other sets of portfolios involve a double sort on a stock characteristic (size, illiquidity, momentum, book-to-market and idiosyncratic volatility ) and the volatility of liquidity. The stock characteristics and volatility of liquidity are computed as described in Table 1. The sample consists of common stocks listed on AMEX and NYSE from January 1964 to December 2010. The portfolios are rebalanced every month and we skip a week between portfolio formation and the holding period. The table also presents the average returns of the high-minus-low volatility of liquidity strategy, P 5P 1, within each sort, together with the corresponding Fama-French four factor alphas (F F 4). Newey-West t-statistics are shown below the average returns. Mean Portfolio Returns All Stocks EW P1 P2 P3 P4 P5 P5 P1 t-statistic F F 4 alphas t-statistic 1.05 1.15 1.24 1.31 1.36 0.31 2.82 0.31 3.02 VW 0.84 0.86 0.96 1.03 1.16 0.31 2.73 0.25 2.86 S1 1.14 1.30 1.29 1.44 1.46 0.32 2.05 0.42 2.22 Size S2 1.10 1.23 1.33 1.37 1.39 0.29 2.81 0.41 4.39 S3 0.96 1.00 1.09 1.07 1.03 0.07 0.74 0.10 1.09 IL1 0.99 1.03 1.13 1.09 1.20 0.20 2.26 0.27 3.13 Illiquidity IL2 1.07 1.19 1.35 1.33 1.35 0.28 2.58 0.39 4.06 IL3 1.15 1.32 1.22 1.44 1.45 0.30 2.27 0.39 2.54

Momentum M1 P1 P2 P3 P4 P5 P5 P1 t-statistic F F 4 alphas t-statistic 0.71 0.87 0.88 1.09 1.07 0.36 2.30 0.12 0.78 M2 1.04 1.08 1.25 1.25 1.47 0.43 3.97 0.35 3.49 M3 1.31 1.44 1.55 1.61 1.74 0.43 3.89 0.57 5.58

Book-to-Market BM1 0.90 0.97 1.10 1.10 1.00 0.11 0.89 0.10 0.93 BM2 1.05 1.14 1.19 1.21 1.32 0.28 2.33 0.29 2.47 BM3 1.32 1.43 1.41 1.56 1.59 0.26 2.01 0.29 2.03

Idiosyncratic Vol. IV1 1.08 1.11 1.24 1.19 1.24 0.16 1.89 0.16 2.09 IV2 1.20 1.31 1.37 1.42 1.50 0.31 2.64 0.36 3.42 IV3 0.88 1.07 1.09 1.31 1.31 0.44 2.69 0.42 2.39

38

Table III: Fama-MacBeth Regression Estimates using Individual Security Data

This table presents the results from Fama-MacBeth regressions in which the dependent variables are stock returns and the independent variables are various stock characteristics. The sample consists of common stocks listed on AMEX and NYSE from January 1964 to December 2010. The stock characteristics are dened in Table 1. In Panel A the dependent variables are excess stock returns, while in Panel B the dependent variables are risk-adjusted stock returns. Risk-adjustment is based on the Fama-French 3-factor model augmented with a momentum factor. In both panels the independent variables are various stock characteristics in both percentile ranks (standardized between zero and one) and real values. When real values of independent variables used we apply log transformations to SIZE, BM , and T U RN . To minimize microstructure issues, one week is skipped between measurement of the independent and dependent variables and all models are estimated using Weighted Least Squares (weight equals 1 + gross lagged stock return). Coecient estimates are multiplied by 100. Newey-West t-statistics are reported below the coecient estimates.

A: Excess Returns Ranks Ranks Ranks Real ivolliq illiq Cov(r, c) IV OL

R c R r C r C c

B: Risk-adjusted Returns Real Real Ranks Ranks Ranks Real 0.21 3.12 0.54 3.03 -0.10 -1.23 -0.79 -4.80 -0.20 -2.91 0.29 1.94 0.15 1.38 0.12 1.82 Real Real 0.26 0.29 0.15 3.88 4.06 2.32 -0.50 0.05 0.08 0.05 -1.11 2.08 3.16 2.83 -0.02 1.77 1.56 -0.25 1.27 1.18 -0.50 -25.66 -28.90 -3.83 -6.82 -7.84 -0.20 0.00 0.00 0.00 -2.69 -0.03 -0.08 0.04 0.17 0.03 0.09 0.07 1.45 0.39 1.39 1.38 0.12 2.11 2.18 1.68 1.16 1.05 1.19 0.95 0.12 0.00 0.00 0.00 1.92 -0.29 -0.47 -0.21 -1.09 -0.14 -2.44 -6.64 0.54 0.17 4.75 4.17 0.98 0.49 3.92 3.07 -0.50 -0.12 -5.66 -3.53 -0.10 0.04 -0.66 0.78 0.03 0.02 0.03 0.04

0.41 1.36

-0.20 -3.03 0.24 1.00 0.12 1.55 0.09 1.36

0.22 3.48 0.58 2.60 -0.05 -0.75 -0.59 -2.06 -0.20 -2.65 0.44 2.50 0.09 1.28 0.07 1.09

SIZE BM RET 12M SKEW T U RN Adj.R2 0.03 0.04

0.27 0.32 0.17 4.49 3.99 2.71 0.12 0.04 0.06 0.04 0.37 1.29 2.04 2.61 0.01 1.37 1.31 0.18 1.16 1.06 -0.50 -19.54 -27.12 -2.92 -3.31 -7.17 -0.10 0.00 0.00 0.00 -2.49 0.78 0.39 0.39 0.25 0.09 0.13 0.09 2.37 1.08 1.95 2.18 0.08 2.76 1.70 1.64 1.19 1.21 0.95 1.02 0.09 -0.01 -0.01 0.00 1.61 -1.29 -1.13 -0.56 -0.69 -0.16 -1.91 -3.61 0.69 0.23 3.89 3.60 1.34 0.68 5.18 3.36 -0.30 -0.07 -4.75 -2.76 0.20 0.10 1.00 1.92 0.07 0.03 0.05 0.07

0.21 1.13

-0.30 -3.11 0.02 0.14 0.16 1.45 0.13 2.06

0.01

0.02

39

Table IV: Fama-MacBeth Regression Estimates by Size Group

This table presents the results from Fama-MacBeth regressions within three separate size groups. The sample consists of common stocks listed on AMEX and NYSE from January 1964 to December 2010. The stock characteristics are dened in Table 1. In Panel A the dependent variables are excess stock returns, while in Panel B the dependent variables are risk-adjusted stock returns. Risk-adjustment is based on the Fama-French 3-factor model augmented with a momentum factor. In both panels the independent variables are various stock characteristics in percentile ranks (standardized between zero and one). To minimize microstructure issues, one week is skipped between measurement of the independent and dependent variables and all models are estimated using Weighted Least Squares (weight equals 1 + gross lagged stock return). Coecient estimates are multiplied by 100. Newey-West t-statistics are reported below the coecient estimates.

A: Excess Returns Small ivolliq illiq COV (r, c) IV OL

R c R r C r C c

B: Risk-adjusted Returns Small 0.35 2.79 1.19 2.02 0.21 1.99 -0.79 -3.74 -0.20 -1.64 -0.01 -0.05 0.08 0.67 0.09 0.98 0.93 4.47 1.68 6.52 -0.79 -5.51 0.35 0.97 0.02 Medium 0.19 1.89 0.47 1.55 -0.30 -1.71 -0.69 -4.51 -0.20 -1.84 0.30 1.73 0.15 1.21 0.13 1.42 0.46 3.17 0.78 2.75 -0.30 -3.35 0.20 1.03 0.03 Large 0.15 1.85 0.26 1.00 -0.89 -4.06 -0.50 -3.03 -0.20 -0.86 0.16 0.99 0.13 1.02 0.13 0.93 0.23 1.52 0.44 1.53 -0.02 -0.28 0.15 0.93 0.05

Medium 0.19 2.13 0.73 2.15 -0.20 -1.45 -0.59 -3.86 -0.10 -1.19 0.35 2.55 0.18 1.79 0.06 0.76 0.60 3.07 1.13 3.87 -0.10 -1.77 0.44 2.04 0.06

Large 0.10 1.38 0.60 1.80 -0.69 -3.36 -0.40 -2.27 -0.08 -0.54 0.25 1.70 0.06 0.62 0.05 0.46 0.42 2.26 0.87 3.12 0.01 0.12 0.42 1.99 0.10

BM RET 12M SKEW T U RN Adj.R2

0.48 3.81 1.41 2.33 0.21 2.42 -0.79 -3.35 -0.10 -1.55 0.13 1.11 0.03 0.39 0.08 0.96 1.01 4.35 1.99 7.47 -0.59 -4.45 0.59 1.77 0.04

40

Table V: Fama MacBeth Regression Estimates: Using Dierent Measurement

Periods for the Volatility of Liquidity

This table presents the results from Fama-MacBeth regressions in which the dependent variables are stock returns and the independent variables are various stock characteristics. The sample consists of common stocks listed on AMEX and NYSE from January 1964 to December 2010. The stock characteristics are dened in Table 1. ivolliq3M is ivolliq measured over 3 months, while ivolliq6M is measured over 6 months. In Panel A the dependent variables are excess stock returns, while in Panel B the dependent variables are risk-adjusted stock returns. Risk-adjustment is based on the Fama-French 3-factor model augmented with a momentum factor. In both panels the independent variables are various stock characteristics in both percentile ranks (standardized between zero and one) and real values. When real values of independent variables used we apply log transformations to SIZE, BM , and T U RN . To minimize microstructure issues, one week is skipped between measurement of the independent and dependent variables and all models are estimated using Weighted Least Squares (weight equals 1 + gross lagged stock return). Coecient estimates are multiplied by 100. Newey-West t-statistics are reported below the coecient estimates.

A: Excess Returns Ranks ivolliq3M ivolliq6M illiq COV (r, c) IV OL

R c R r C r C c

B: Risk-adjusted Returns Real Ranks 0.25 2.40 Real 0.24 3.34 0.32 2.29 -0.50 -1.11 -0.04 -0.44 -0.59 -4.01 -0.20 -2.66 0.18 1.49 0.11 1.14 0.11 1.72 -0.99 -2.33 0.55 4.88 0.97 4.09 -0.50 -5.60 -0.10 -0.51 0.03 0.21 2.68 0.05 3.61 1.21 1.14 -29.38 -8.46 0.00 -0.49 0.07 1.31 1.36 0.81 0.00 0.24 -0.12 -6.08 0.17 4.18 0.47 2.99 -0.12 -3.59 0.07 1.29 0.04 Ranks Real

Real 0.28 4.48

Ranks

0.29 3.74

SIZE BM RET 12M SKEW T U RN Adj.R2

0.04 0.11 0.01 0.11 -0.50 -2.94 -0.10 -2.55 0.25 2.38 0.07 1.04 0.09 1.60 -0.79 -1.98 0.70 3.95 1.33 5.25 -0.30 -4.84 0.21 1.06 0.06

0.04 2.97 1.10 1.11 -27.57 -7.42 0.00 -0.12 0.09 2.06 1.14 0.75 0.00 -0.45 -0.14 -3.37 0.23 3.59 0.67 3.34 -0.07 -2.95 0.12 2.46 0.07

0.37 3.58 -0.01 -0.03 0.01 0.11 -0.50 -3.01 -0.10 -2.46 0.20 2.49 0.07 1.05 0.09 1.55 -0.69 -1.91 0.70 3.94 1.32 5.21 -0.30 -4.95 0.21 1.04 0.06

0.24 3.36 0.05 3.38 1.14 1.20 -27.45 -7.50 0.00 -0.12 0.09 2.06 1.12 0.73 0.00 -0.37 -0.14 -3.38 0.23 3.63 0.65 3.24 -0.07 -2.95 0.12 2.48 0.07

-0.50 -1.08 -0.03 -0.38 -0.59 -4.06 -0.20 -2.78 0.17 1.44 0.12 1.13 0.11 1.73 -0.99 -2.40 0.56 4.92 0.97 3.95 -0.50 -5.45 -0.10 -0.53 0.03

0.05 3.42 1.16 1.06 -29.54 -8.35 0.00 -0.35 0.07 1.27 1.27 0.76 0.00 -0.02 -0.13 -6.24 0.17 4.09 0.48 3.01 -0.12 -3.58 0.06 1.19 0.04

41

Table VI: Fama MacBeth Regression Estimates: Using a Dierent

Measurement Period for Illiquidity

This table presents the results from Fama-MacBeth regressions in which the dependent variables are stock returns and the independent variables are various stock characteristics. The sample consists of common stocks listed on AMEX and NYSE from January 1964 to December 2010. The stock characteristics are dened in Table 1. illiq1Y is dened as the average Amihud measure of liquidity over the past 252 days. We require at least 126 trading days with a valid daily Amihud measure to calculate illiq1Y . In Panel A the dependent variables are excess stock returns, while in Panel B the dependent variables are risk-adjusted stock returns. Risk-adjustment is based on the Fama-French 3-factor model augmented with a momentum factor. In both panels the independent variables are various stock characteristics in both percentile ranks (standardized between zero and one) and real values. When real values of the independent variables used we apply log transformations to SIZE, BM , and T U RN . To minimize microstructure issues, one week is skipped between measurement of the independent and dependent variables and all models are estimated using Weighted Least Squares (weight equals 1 + gross lagged stock return). All coecients are multiplied by 100. Newey-West t-statistics are reported below the coecients.

A: Excess Returns Ranks ivolliq illiq1Y COV (r, c) IV OL

R c R r C r C c

B: Risk-adj. Returns Ranks 0.24 3.36 0.38 0.60 -0.02 -0.29 -0.59 -4.74 -0.20 -2.73 0.20 1.67 0.13 1.22 0.12 1.97 -0.30 -0.51 0.56 4.91 0.95 4.18 -0.40 -5.76 0.08 0.53 0.03 Real 0.13 2.09 0.05 3.84 1.55 1.35 -31.17 -8.34 -0.00 -0.33 0.07 1.34 2.23 1.24 0.00 0.41 -0.14 -6.42 0.17 4.16 0.47 2.96 -0.12 -3.56 0.05 0.87 0.07

Real 0.15 2.54 0.05 4.24 1.32 1.18 -29.36 -7.59 -0.00 -0.01 0.09 2.19 2.28 1.39 -0.00 -0.23 -0.15 -3.44 0.23 3.62 0.66 3.30 -0.07 -2.76 0.10 2.08 0.07

SIZE BM RET 12M SKEW T U RN Adj.R2

0.20 3.13 0.15 3.62 0.01 0.08 -0.69 -4.03 -0.10 -2.57 0.28 2.62 0.09 1.32 0.10 1.72 0.54 1.20 0.72 4.10 1.21 4.80 -0.30 -5.03 0.52 3.19 0.07

42

Table VII: Fama MacBeth Regression Estimates: Using the Predicted Value of

the Volatility of Liquidity

This table presents the results from Fama-MacBeth regressions in which the dependent variables are stock returns and the independent variables are various stock characteristics. The sample consists of common stocks listed on AMEX and NYSE for period from January 1964 to December 2010. The stock characteristics are dened in Table 1. The volatility of liquidity is estimated from a cross-sectional model. Specically, we run a cross-sectional regression of ivolliq, measured over the same holding period as returns, on rm characteristics measured at the end of the previous month. In the cross-sectional regressions we use two lags of ivolliq, SIZE, BM , IV OL, RET 1M , RET 12M , illiq, and T U RN . Then we use the tted values of ivolliq from the cross-sectional regressions as independent variables in the subsequent Fama-MacBeth regressions. The tted value is denoted by F ivolliq. In Panel A the dependent variables are excess stock returns, while in Panel B the dependent variables are risk-adjusted stock returns. Risk-adjustment is based on the Fama-French 3-factor model augmented with a momentum factor. In both panels the independent variables are various stock characteristics in both percentile ranks (standardized between zero and one) and real values. When real values of independent variables used we apply log transformations to SIZE, BM , and T U RN . To minimize microstructure issues, one week is skipped between measurement of the independent and dependent variables and all models are estimated using Weighted Least Squares (weight equals 1 + gross lagged stock return). Coecient estimates are multiplied by 100. Newey-West t-statistics are reported below the coecient estimates.

A: Excess Returns Ranks F ivolliq illiq COV (r, c) IV OL

R c R r C r C c

B: Risk-adj. Returns Ranks 0.82 3.25 -1.09 -2.08 -0.02 -0.24 -0.50 -3.57 -0.20 -2.65 0.18 1.55 0.13 1.20 0.13 2.00 -1.19 -2.60 0.49 4.12 0.98 3.94 -0.40 -5.40 -0.05 -0.26 0.03 Real 1.48 4.24 0.05 2.69 1.47 1.14 -30.89 -8.22 0.00 -0.02 0.07 1.40 1.56 0.88 0.00 -0.33 -0.06 -2.45 0.15 3.58 0.49 3.08 -0.11 -3.36 0.15 2.66 0.04

Real 1.26 4.17 0.04 2.56 1.20 0.99 -28.66 -7.53 0.00 0.36 0.09 2.18 1.48 0.93 0.00 -0.65 -0.09 -2.13 0.22 3.30 0.68 3.38 -0.06 -2.51 0.18 3.37 0.07

SIZE BM RET 12M SKEW T U RN Adj.R2

0.51 2.73 -0.20 -0.56 0.01 0.19 -0.50 -2.84 -0.10 -2.43 0.26 2.41 0.08 1.20 0.10 1.66 -0.79 -1.98 0.66 3.72 1.35 5.24 -0.30 -4.49 0.25 1.27 0.07

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Table VIII: Alternative Specication of Residual Liquidity

This table presents the results from Fama-MacBeth regressions in which the dependent variables are stock returns and the independent variables are various stock characteristics. The sample consists of common stocks listed on AMEX and NYSE from January 1964 to December 2010. ivolliq is the coecient of variation of liquidity calculated as standard deviation of residual liquidity, obtained by regressing daily stock illiquidity on daily market illiquidity and daily Fama and French three factors over a month, normalized by mean level of liquidity. The stock characteristics are dened in Table 1. In Panel A the dependent variables are excess stock returns, while in Panel B the dependent variables are risk-adjusted stock returns. Risk-adjustment is based on the Fama-French 3-factor model augmented with a momentum factor. In both panels the independent variables are various stock characteristics in both percentile ranks (standardized between zero and one) and real values. When real values of independent variables used we apply log transformations to SIZE, BM , and T U RN . To minimize microstructure issues, one week is skipped between measurement of the independent and dependent variables and all models are estimated using Weighted Least Squares (weight equals 1 + gross lagged stock return). Coecient estimates are multiplied by 100. Newey-West t-statistics are reported below the coecient estimates.

A: Excess Returns Ranks Ranks ivolliq illiq COV (r, c) IV OL

R c R r C r C c

B: Risk-adjusted Returns Real Ranks Real 0.22 3.31 0.55 3.06 -0.10 -1.26 -0.79 -4.87 -0.20 -2.91 0.30 1.98 0.15 1.40 0.12 1.92 Real Real 0.26 0.30 0.15 3.85 4.01 2.26 -0.50 0.08 0.05 -1.04 3.21 2.86 -0.02 1.79 1.58 -0.29 1.28 1.20 -0.59 -25.70 -28.97 -3.96 -6.82 -7.87 -0.20 0.00 0.00 -2.65 -0.07 0.05 0.18 0.09 0.07 1.51 1.37 1.38 0.13 2.26 1.75 1.18 1.22 0.98 0.13 0.00 0.00 2.05 -0.41 -0.20 -1.09 -0.14 -2.42 -6.72 0.55 0.17 4.77 4.17 0.98 0.49 3.92 3.07 -0.40 -0.12 -5.51 -3.51 -0.10 0.04 -0.62 0.77 0.02 0.03 0.03 0.04

Real

0.20 3.20 0.60 2.71 -0.05 -0.77 -0.59 -2.09 -0.20 -2.65 0.44 2.50 0.09 1.29 0.07 1.23

SIZE BM RET 12M SKEW T U RN Adj.R2 0.04

0.23 0.31 0.16 3.97 3.81 2.40 0.17 0.06 0.04 0.51 2.06 2.65 0.01 1.39 1.32 0.13 1.18 1.07 -0.50 -19.51 -27.17 -3.01 -3.31 -7.19 -0.10 0.00 0.00 -2.46 0.41 0.41 0.26 0.13 0.09 2.38 1.92 2.17 0.08 1.79 1.71 1.22 1.00 1.06 0.11 -0.01 0.00 1.79 -1.06 -0.51 -0.69 -0.16 -1.87 -3.64 0.70 0.23 3.90 3.60 1.34 0.68 5.17 3.37 -0.30 -0.07 -4.67 -2.74 0.21 0.10 1.06 1.91 0.07 0.05 0.07

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