Market Microstructure and Asset Pricing: On the Compensation for Illiquidity in Stock Returns

Models of price formation in securities markets suggest that privately informed investors create significant illiquidity costs for uninformed investors, implying that the required rates of return should be higher for securities that are relatively illiquid. An investigation is made of the empirical relation between monthly stock returns and measures of illiquidity obtained from intraday data. A significant relation is found between required rates of return and these measures after adjusting for the Fama and French risk factors, and also after accounting for the effects of the stock price level.