Stock Liquidity and the Cost of Equity Capital in Global Markets

[Extract] Conventional finance theory proposes that the cost of equity capital is determined primarily by risk. The greater the risk (holding all else constant), the higher the expected return demanded by risk-averse investors as compensation. The classic capital asset pricing model (CAPM) proposes that the asset's expected return is an increasing function of its undiversifiable systematic risk - its covariance with the market portfolio, or δ - and is unaffected by its unsystematic diversifiable risk. However, empirical tests on the pricing of stocks usually do not find support for the pricing of stock δ, and the evidence on the pricing of the unsystematic risk is that the return-risk relation is negative, both in the U.S. and around the world. In this paper we present global evidence in support of an alternative theory of asset pricing: stock illiquidity is priced, and thus a stock's expected return is an increasing function of a stock's illiquidity or trading costs.