Liquidity Risk and Expected Stock Returns in Korea: A New Approach

We propose a simple way to capture the multidimensionality of liquidity. Our analysis indicates that existing liquidity measures have considerable asset specific components, which justifies our new approach. Constructing a two‐factor model with the market and liquidity factor proposed in this paper, we find that our two‐factor model explains well the cross‐section of stock returns in K orea from 1987 to 2010, describing the liquidity premium, size and value effects that the CAPM and F ama‐ F rench three‐factor model fail to explain. Our results also show that the role of liquidity risk on expected stock returns is especially pronounced during the post‐ A sian financial crisis period.