The role of an illiquidity risk factor in asset pricing: Empirical evidence from the Spanish stock market

The main purpose of this study is to construct an illiquidity risk factor for the Spanish stock market over the 1994–2002 period. Because of the absence of consensus in empirical research about the most appropriate liquidity measure, we applied the Amihud [Amihud, Y. (2002). Illiquidity and stock returns: Cross-section and time-series effects. Journal of Financial Markets 5, 31–56] illiquidity ratio that shows the price response associated with one euro of trading volume. Moreover, we generated an illiquidity factor using the Fama and French [Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics 33, 3–56] orthogonal approach and analyzed whether it enters the stochastic discount factor as an additional state variable. We conclude that systematic illiquidity should be a key ingredient of asset pricing.