The Amihud and Mendelson (1986) pricing model discussed in the previous section shows the sensitivity of asset prices to liquidity. In reality, liquidity is not a constant but fluctuates substantially over time. Previous article, which graphed the quoted and effective bid–ask spread over time, illustrates this point. Recent studies on equity market liquidity, such as Chordia, Roll and Subrahmanyam (2000, 2001) and Hasbrouck and Seppi (2001), show that there is commonality in liquidity, i.e. shocks to the liquidity of individual stocks contain a common component. Moreover, returns on stocks tend to be correlated with changes in market-wide liquidity.

These results warrant investigating liquidity as a priced risk factor. In this setup, it is not only the level of transaction costs that determines asset prices, but also the exposure of returns to fluctuations in market-wide liquidity. Indeed, recent literature has shown that the (systematic) risk associated with common liquidity fluctuations is priced in the cross-section of expected equity returns. Pioneering work in this area was done by Amihud (2002). Important recent papers in this growing literature include Acharya and Pedersen (2005), Pastor and Stambaugh (2003) and Sadka (2006), who all document the significance of liquidity risk for the expected returns on equities.