Characteristic liquidity, systematic liquidity and expected returns

• We test the characteristic hypothesis vs. risk hypothesis for the liquidity effect.
• We develop a CAPM liquidity-augmented risk model by employing a new liquidity measure.
• This two-factor risk model explains the liquidity premium over 1931–2008 data.
• The liquidity characteristic hypothesis for the liquidity effect is rejected.

We investigate whether the effect of liquidity on equity returns can be attributed to the liquidity level, as a stock characteristic, or a market wide systematic liquidity risk. We develop a CAPM liquidity-augmented risk model and test the characteristic hypothesis against the systematic risk hypothesis for the liquidity effect. We find that the two-factor systematic risk model explains the liquidity premium and the null hypothesis that the liquidity characteristic is compensated irrespective of liquidity risk loadings is rejected. This result is robust over 1931–2008 data and sub-samples of pre-1963 and post-1963 data both in the time-series and the cross-sectional analysis. Our findings provide clear guidance on the impact of liquidity on expected returns and can have practical implications in portfolio construction and investment strategies.