Idiosyncratic Volatility of Liquidity and Expected Stock Returns

We show that idiosyncratic liquidity risk is positively priced in the cross-section of stock returns. Our measure of idiosyncratic liquidity volatility is based on a ”market” model for stock liquidity. Idiosyncratic volatility of liquidity is priced in the presence of systematic liquidity risk: the covariance of stock returns with aggregate liquidity, the covariance of stock liquidity with aggregate liquidity, and the covariance of stock liquidity with the market return. Our results are puzzling in light of Acharya and Pedersen (2005) who develop a model in which only systematic liquidity risk affects returns.