A liquidity-augmented capital asset pricing model

Using a new measure of liquidity, this paper documents a significant liquidity premium robust to the CAPM and the Fama-French three-factor model and shows that liquidity is an important source of priced risk. A two-factor (market and liquidity) model well explains the cross-section of stock returns, describing the liquidity premium, subsuming documented anomalies associated with size, long-term contrarian investment, and fundamental (cashflow, earnings, and dividend) to price ratios. In particular, the two-factor model accounts for the book-to-market effect, which the Fama-French three-factor model fails to explain. (c) 2006 Elsevier B.V. All rights reserved.