Illiquidity contagion and pricing of commonality risk: Evidence from a dynamic conditional correlation model

This paper investigates the pricing of the commonality in liquidity risk in the U.S. stock market by using a more comprehensive measure of market illiquidity cost that can reflect the liquidity condition of broader asset markets, and by forming portfolios in a way that is consistent with the definition of the commonality risk. Estimating a conditional version of the Liquidity-Adjusted Capital Asset Pricing Model by the Dynamic Conditional Correlation approach, we find a commonality risk premium that is higher than those derived from alternative measures. The premium is time varying, with values being higher during periods of market turmoil.

Automated summary

This study examines the pricing of commonality in liquidity risk in the U.S. stock market using a comprehensive measure of market illiquidity cost and forming portfolios based on the definition of commonality risk. By estimating a conditional version of the Liquidity-Adjusted Capital Asset Pricing Model through the Dynamic Conditional Correlation approach, it finds a time-varying commonality risk premium, with higher values during periods of market turmoil.