Asset pricing with extreme liquidity risk

Defining extreme liquidity as the tail of the illiquidity for all stocks, I propose a direct measure of market-wide extreme liquidity risk and find that it is priced cross-sectionally in the U.S. Between 1973 and 2014, the stocks with high extreme liquidity risk beta earned value-weighted average return of 5.88% annually higher than the stocks with low extreme liquidity risk beta, adjusted for the illiquidity level premium and exposures to aggregate liquidity risk as well as the market, size and value factors. The extreme liquidity risk premium is different from that on aggregate liquidity risk documented in Pastor and Stambaugh (2003) as well as that based on the tail risk in return of Kelly and Jiang (2014). Extreme liquidity risk provides an advance warning about extreme liquidity events. I explore potential economic mechanisms through which the rare and large fluctuations in stock-level liquidity are priced.