The liquidity premium is the extra return investors require to hold assets with higher trading costs, where the bid-ask spread measures illiquidity. In "Asset Pricing and the Bid-Ask Spread," Amihud and Mendelson (1986) studied NYSE stocks from 1961 to 1980. Using 49 portfolios built from CRSP returns and Fitch quotes, they found a 1% spread increase raised monthly risk-adjusted excess return by 0.211% (t=6.83). The correlation between portfolio excess return and spread was 0.239, roughly twice the 0.123 correlation with beta.
What the Study Found
Excess returns increased in both beta and spread, with a spread coefficient of 0.211 (t=6.83) and a beta coefficient of 0.00672 (t=6.18). The difference in monthly mean excess return between the highest- and lowest-spread groups was 0.857% under OLS and 0.681% under GLS. The beta coefficient of 0.00672 closely matched 0.00671, the average monthly excess return on common stocks over the period. Adding firm size as log(SIZE) left the spread effect intact, while the size coefficient stayed insignificant (t=1.56). A formal F-test for the spread variables given log(SIZE) produced F=2.02, significant at the 0.01 level.
Methodology
The data combined CRSP monthly returns with relative bid-ask spreads from Fitch's Stock Quotations on the NYSE. Stocks were sorted into 49 (7×7) spread-and-beta portfolios, yielding 980 portfolio-year observations across twenty overlapping eleven-year periods. Each eleven-year period used a five-year beta estimation period, a five-year portfolio formation period, and a one-year cross-section test period within 1961–1980. The pooled cross-section/time-series regressions controlled for relative risk (beta) and year fixed effects, estimated by both OLS and GLS.
Key Statistics
| Metric | Finding | Context |
|---|---|---|
| Spread coefficient | 0.211 (t=6.83) | 1% spread rise → +0.211% monthly risk-adjusted excess return, 1961–1980 |
| High vs. low spread group | 0.857% (OLS); 0.681% (GLS) | Monthly mean excess-return difference, extreme spread groups |
| Return–spread correlation | 0.239 vs. 0.123 | Correlation with spread vs. correlation with beta, full sample |
| Spread-adjusted return | r_ij = d_j/V_j − μ_i·S_j | Gross return minus expected liquidation cost per unit time (Eq. 4) |
| Equilibrium gross return | d_j/V_j* = min_i {r_i* + μ_i·S_j} | Increasing, concave, piecewise-linear return–spread relation (Eq. 6) |
Why This Matters
Liquidity is not a friction to be ignored but a priced characteristic of every security. Firms can lower their cost of capital by improving the marketability of their shares. Investors accept lower gross returns for assets that are cheaper to trade. For portfolio managers, expected trading costs should be weighed directly against expected returns when selecting assets. The result also offers a rational, microstructure-based reading of the small-firm effect, framing part of it as compensation for illiquidity rather than an anomaly.