Betas and Liquidity: Differences in Systematic Price Risk Due to Asymmetric Asset Liquidity and Correlated Funding Shocks

This research presents evidence for the existence of differences in asset beta risk in the liquidity cross-section of assets due to correlated trading. It is argued that due to differences in liquidity or cost, most trading activity is concentrated on the subset of liquid assets. In the presence of systematic wealth shocks this leads to an increase in beta risk for the liquid asset class beyond their true level of risk from the underlying dividend process with regard to the market risk factor. Vice-versa, the risk of illiquid assets becomes understated. Moreover it is argued that a reduction of trading cost in the cross-section will reduce such differences and lead to a convergence of risk factor estimates towards the true value of underlying risk. Empirical evidence using data surrounding the tick-reduction event at the New York Stock Exchange is supporting this conjecture. It is found that beta estimates for liquid assets exceed their illiquid peers, while the difference in beta between the groups is significantly reduced after the exogenous trading cost reduction due to the tick-change event.