Consumption, liquidity and the cross-sectional variation of expected returns

Recent papers in asset pricing have added a market-wide liquidity factor to traditional portfolio-based or factor models. However, none of these papers has reported any evidence on how aggregate liquidity behaves together with consumption growth risk. This paper covers this gap by providing a comprehensive analysis of the cross-sectional variation of average returns under ultimate consumption risk and market-wide illiquidity shocks. It derives closed-form expressions for consumption-based stochastic discount factors adjusted by aggregate illiquidity shocks and tests alternative model specifications. We find that market-wide illiquidity risk seems to be especially useful in explaining the size-based cross-sectional differences of average returns. We also find a strongly negative and highly significant illiquidity risk premium under recursive preferences for the first quarter of the year suggesting a time-varying behaviour of the market-wide illiquidity premium.stochastic discount factor, ultimate consumption risk, market-wide liquidity, illiquidity premium seasonality.