Illiquidity in asset pricing and as investment strategy : an empirical analysis

Abstract

This Master’s thesis examines the illiquidity premium. In the first part of the thesis, we analyse whether a traded illiquid-minus-liquid (IML) return factor helps in explaining the cross-section of expected returns. In the second part, we investigate whether the illiquidity premium can be captured in practice. In our asset pricing tests, we find some evidence in favour of adding IML to both, the Fama and French three- and five-factor model. For most test portfolios, IML improves the description of average excess returns. The improvements are larger when switching from the three-factor model to its IML-augmented version than when adding IML to the five-factor model. With regards to how implementable an illiquidity strategy is in practice, we find that the illiquidity premium is largely concentrated among small firms. This pattern does not change over time. When considering market-adjusted returns, we show that the illiquidity premium is driven mostly by the long side, though not entirely. The contribution of the long and short side changes over time. Further, we present some evidence that the contribution of the long and the short side varies across firm size. For the smallest firms, shorting is less important than for the biggest firms. Moreover, we find that the illiquidity premium has decreased over time. Given our results, we conclude that it is highly unlikely that the illiquidity premium can be captured in practice.