The relative-relative liquidity premium and cross-sectional returns: Evidence from China

We propose an aggregate liquidity factor using a principal component analysis approach to measure different aspects of illiquidity information in Chinese markets. We aggregate information on 7 liquidity-related trading-volume- and price-volatilitybased characteristics to build the new illiquidity factor (LiqAR). To eliminate the sentiment and moment information introduced into the LiqAR during the aggregating process, we standardized the LiqAR in both horizontal and vertical directions. We evaluate various factor pricing models incorporating the relative-relative LiqAR factors and find that the new LiqAR factor generates significantly higher cross-sectional stock returns than convenience illiquidity factors. The results remain robust after introducing different pricing factors, such as size, book-to-market ratio, and earnings-to-price ratio. The new 2, 3, and 4 factor pricing models can account for numerous return anomalies.