A recent paper from Robeco discusses whether a liquidity premium exists in the stock market. The authors, David Blitz, Jean-Paul van Brakel, and Milan Vidojevic, conclude that “the evidence for such a premium is, at best, weak.”

Less politely, these authors refer to the whole notion of a liquidity premium as having been “challenged and debunked in various studies.”

Theory and Practice

In a sense there “should” be a liquidity premium. The more illiquid a stock, the more difficult it is to trade it, which on some models means that illiquid stocks are less attractive than liquid stocks, and should command a premium. One should have to be bribed to hold an illiquid stock just as one has to be bribed to hold a risky one.

The question of whether there exists such a premium in empirical fact is analogous to, though distinct from, questions about the size of the credit risk premium of corporate bonds. There is an appearance in the world of corporate bonds that this “risk” premium is greater than the risk justifies, higher than would be warranted by losses due to defaults. This is sometimes interpreted to mean that some of “risk” premium that actually is liquidity related. Blitz et al raise that analogy in a footnote but in the body of their article they stick with the question of a liquidity premium in the public stock markets.

Amihud and Mendelsonaddressed this question more than thirty years ago in a paper in the Journal of Financial Markets. They said that postulating a liquidity risk premium resolves a puzzle raised by the capital asset-pricing model. Given CAPM, expected stock returns should increase linearly with their market betas. But that doesn’t happen. Stock with low betas earn higher returns than the model predicts.

Why is that so? Amihud and Mendelson proposed that this is so because CAPM assumes away friction, and this illiquidity. Once that assumption is lifted, the differences between model and empirical results can be explained.