Extreme Liquidity Risk, Its Premium from Market Downturns, and the Cross-Section of Stock Returns

I construct a measure of the extreme liquidity risk factor based on the contraction and expansion of monthly cross-sectional distributions of individual illiquidity measures and investigate its asset pricing implications. I find strong empirical evidence (1) that the extreme liquidity risk is priced in the cross-section of expected stock returns and (2) that its premium comes only from market-downturn loadings. The extreme liquidity risk commands an annual premium of 3.3% for one standard deviation increase in its market-downturn loading. The main findings still hold after controlling for known factor loadings, including the loadings of liquidity risk factor and return tail risk factor, as well as various rm characteristics, including size, book-to-market, momentum, Amihud illiquidity level, and extreme Amihud illiquidity level. The cross-sectional pricing evidence of the extreme liquidity risk survives (1) time-varying factor loadings, (2) extended test portfolios augmented by 30 Fama-French industry portfolios, and (3) diagnostic tests for a useless factor