Liquidity Risk and Asset Pricing: Evidence from Amman Stock Exchange

Abstract

The main aim of this study is to investigate the effect of liquidity risk on the explanatory power of the original three-factor model that was introduced by Fama and French, using the turnover ratio measurement as liquidity proxies. Monthly data for the period from January 2007 to December 2013 of a sample of 56 companies listed in Amman Stock Exchange (ASE) was utlilized. The study shows the existence of size, value and liquidity effects. The liquidity factor improves the explanatory power of the original model and is significant in most portfolios, when applied in the Jordanian financial market. The study also shows that adding the liquidity factor can improve the explanatory power of the CAPM and the Fama and French three-factor model. The study advices investors and portfolio managers to use the liquidity four-factor model, because this model provides better explanation to the variation in the portfolio return.