Illiquidity premium and expected stock returns in the UK: A new approach

•A single illiquidity measure is proposed to capture the multidimensionality of illiquidity.•Both parametric and non-parametric methods are applied to investigate the relationship between illiquidity and stock returns in the UK.•The inclusion of the illiquidity factor in the capital asset pricing model plays a significant role in explaining stock returns.•The illiquidity-augmented capital asset pricing models yield a small distance error by using Hansen–Jagannathan non-parametric bound.

This study examines the relative importance of liquidity risk for the time-series and cross-section of stock returns in the UK. We propose a simple way to capture the multidimensionality of illiquidity. Our analysis indicates that existing illiquidity measures have considerable asset specific components, which justifies our new approach. Further, we use an alternative test of the Amihud (2002) measure and parametric and non-parametric methods to investigate whether liquidity risk is priced in the UK. We find that the inclusion of the illiquidity factor in the capital asset pricing model plays a significant role in explaining the cross-sectional variation in stock returns, in particular with the Fama–French three-factor model. Further, using Hansen–Jagannathan non-parametric bounds, we find that the illiquidity-augmented capital asset pricing models yield a small distance error, other non-liquidity based models fail to yield economically plausible distance values. Our findings have important implications for managing the liquidity risk of equity portfolios.