Financial theory suggests that expected asset returns are related to systematic risk associated with common factors. In equilibrium, an asset whose returns are more sensitive to risk factors should offer higher returns to compensate investors for holding the asset. The literature has presented several stock market and term structure factors important for the cross section of asset returns. Recent studies have further suggested liquidity as another good candidate for a priced state variable. Liquidity is often viewed as an important feature of the investment environment. All else equal, investors should require higher returns on assets whose returns have greater sensitivities to marketwide liquidity.
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