The components of the illiquidity premium: An empirical analysis of U.S. stocks 1927-2010

This paper implements a conditional version of the liquidity adjusted CAPM (LCAPM). The conditional LCAPM allows for a time-varying decomposition of the total illiquidity premium into a level component and three risk components. The estimated average annual total illiquidity premium for US stocks 1927-2010 is 1.74%-2.08%, which is substantially lower than in most previous studies. The contributions from illiquidity level and illiquidity risk are 1.25%-1.28% and 0.46%-0.83%, respectively. Of the three illiquidity risk components, risk related to the hedging of wealth shocks is the most important, while commonality risk is the least important. The illiquidity premia are clearly time-varying, with peaks in downturns and crises, but with no general tendency to decrease over time. The level premium and the risk premium are significantly positively correlated around 0.35; indicating that in periods of turbulence both illiquidity cost and illiquidity risk premia tend to be high.