Systematic Risk, Liquidity Premia, and the Cross-Section of Expected Returns: A Unified Factor Framework

Abstract

This paper develops and tests a unified multi-factor asset pricing framework that incorporates systematic market risk, size, value, liquidity, and volatility risk premia into a single coherent model for the cross-section of expected equity returns. Using comprehensive data on U.S. common stocks from the Center for Research in Security Prices (CRSP) spanning 1963 to 2023, merged with Compustat accounting data, intraday Trade and Quote (TAQ) microstructure data, and OptionMetrics implied volatility surfaces, we construct tradable factor-mimicking portfolios for each priced risk dimension and evaluate the model's ability to explain average returns on a broad array of test assets. Our liquidity factor, constructed from a composite measure that synthesizes the Amihud (2002) illiquidity ratio, the Pastor and Stambaugh (2003) traded liquidity innovation, and a bid-ask spread measure derived from TAQ data, earns an unconditional premium of 0.41 percent per month (t-statistic = 3.87) and exhibits low correlation with existing Fama and French (2015) factors. Our volatility risk premium factor, constructed as the return differential between portfolios sorted on the spread between option-implied and realized volatility, commands a premium of 0.34 percent per month (t-statistic = 3.21) and captures compensation for bearing aggregate uncertainty risk that is not subsumed by the market or value factors. In formal Fama and MacBeth (1973) cross-sectional regressions on 25 size and book-to-market portfolios, 25 size and momentum portfolios, 10 industry portfolios, and 25 size and illiquidity portfolios, the unified five-factor model (Market, SMB, HML, LIQ, VOL) produces a cross-sectional R-squared of 78 percent and a mean absolute pricing error of 0.07 percent per month, compared with 54 percent and 0.14 percent for the CAPM, 68 percent and 0.11 percent for the Fama-French three-factor model, and 73 percent and 0.09 percent for the Fama-French five-factor model. The GRS test of Gibbons, Ross, and Shanken (1989) fails to reject the null that all pricing errors are jointly zero at conventional significance levels (p-value = 0.127) for our model, whereas it decisively rejects the CAPM (p