The Cross Section of Expected Returns and Amortized Spreads

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Review of Pacic Basin Financial Markets and Policies

Vol. 9, No. 4 (2006) 597638
c World Scientic Publishing Co.

and Center for Pacic Basin Business, Economics and Finance Research
Rev. Pac. Basin Finan. Mark. Pol. 2006.09:597-638. Downloaded from www.worldscientific.com
by CHINESE UNIVERSITY OF HONG KONG on 02/22/15. For personal use only.
The Cross Section of Expected Returns and

Amortized Spreads
Zhongzhi (Lawrence) He
Faculty of Business, Brock University
500 Glenridge Ave., St. Catharines, ON, Canada, L2S 3A1
lhe@brocku.ca
Lawrence Kryzanowski
John Molson School of Business, Concordia University
1455 De Maisonneuve Blvd. West, Montreal, QC, Canada, H3G 1M8
lkryzan@vax2.concordia.ca
The cross-sectional relationship between expected returns and amortized spreads
is studied in an overlapping-generations economy with an average investor. The
commonality in liquidity is directly incorporated into the asset-pricing relation. In
a static equilibrium, the amortized spread of an asset is related to its expected
return through four channels; namely: the equilibrium zero-beta rate, the market
risk premium, a level eect, and an incremental sensitivity eect. Although both
are present over the entire period, their relative importance shifts from a signicant
level to a signicant sensitivity eect from the earlier to most recent sub-period in
the Canadian stock market.
Keywords: Amortized spread; asset pricing; liquidity commonality; clientele eect;
share turnover.
JEL Classication: G11, G12.
1. Introduction
The seminal work of Amihud and Mendelson (1986) establishes the relation
between the required return on an asset and trading costs as measured by
the proportional bid-ask spread. The most prominent result of their work is
the clientele eect of liquidity; namely, given the same level of risk, assets
with higher (lower) proportional spreads are allocated to portfolios with
Corresponding author.
597
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598 Zhongzhi (Lawrence) He & Lawrence Kryzanowski
longer (shorter) expected holding periods. Amihud and Mendelson (1986)

test and report support for their main hypothesis that the market-observed
expected return is an increasing and concave piecewise-linear function of the
proportional spread. If the clientele eect holds in the real economy, then a
description of the spread-return relation is readily obtained for each clientele
of investors. Specically, after rst observing an assets proportional spread,
this spread can be mapped with its required return using the estimated
piecewise-linear function.
The clientele eect of liquidity is generally supported empirically. For
example, Atkins and Dyl (1997) directly support the clientele eect by showing that the length of the holding periods of investors is positively related
to the bid-ask spreads for NYSE stocks. Datar, Naik and Radclie (1998)
test and support an implication of the clientele eect; namely, that asset
returns are negatively related to the turnover rates of assets. More recently,
Kryzanowski and Rubalcava (2005) report empirical ndings that support a
generalized version of the investor clientele hypothesis, which they call the
international trade-venue clientele eect hypothesis.
In summary, the clientele eect of liquidity is an important and widely
supported result that prescribes the return-spread relation for dierent clienteles of investors. However, the clientele eect does not tell us how asset
returns are related to spreads on average (i.e., across investor clienteles).
The average return-spread relation is an important issue in its own right
because it provides an analysis of the incremental required rate of return
for a unit increase in the level and/or the risk of trading costs, not for any
particular investor type, but for the market as a whole.
By examining how asset returns are related on average to transaction
costs, we complement the ndings on the clientele eect in the returnspread literature. We start with the static economy set up used by Amihud
and Mendelson (1986). However, instead of theorizing a positive association
between the holding periods of dierent investor types and proportional
spreads, we aggregate across all the investor types to form a market-average
expected holding period that reects the view of a representative investor.
For a given asset, the proportional spread divided by its average holding period gives rise to the notion of the amortized spread (Chalmers
and Kadlec, 1998), which is a measure of transaction costs for an average
investor. Thus, this paper aims to investigate the cross-sectional relationship
between expected returns and amortized spreads.
As in Amihud and Mendelson (1986), we take the bid-ask spread of each
asset as given. Nevertheless, instead of assuming a deterministic spread,
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A Cross Section Of Expected Returns And Amortized Spreads 599
the spread herein is treated as a random process driven by some underlying liquidity factors. A recent body of literature that documents systematic liquidity motivates this treatment. Using a large transaction database
consisting of NYSE stocks, Chordia, Roll and Subrahmanyam (2000) nd
highly signicant spread correlations among individual securities, and even
stronger spread correlations for portfolios. Huberman and Halka (2001) document the existence of commonality in the bid-ask spreads for 240 size-sorted
NYSE stocks. Using dierent statistical techniques, Hasbrouck and Seppi
(2001) nd that the common factors in liquidity are relatively small. Given
the new evidence of systematic liquidity, Chordia, Roll and Subrahmanyam
(2000, p. 6) make the following statement regarding the impact of trading
costs on asset pricing:
Hence, there are potentially two dierent channels by which trading
costs inuence asset pricing, one static and one dynamic: a static
channel inuencing average trading costs and a dynamic channel
inuencing risk. In future work, it would be of interest to determine whether the second channel is material and, if so, its relative
importance.
Thus, the main contribution of this paper is to derive an asset pricing
relation that formally incorporates the commonalities in liquidity identied in the literature and to formally demonstrate and empirically test the
existence and relative importance of the two channels in asset pricing over
time.
The theoretical part of this paper develops the cross-sectional
relationship between expected returns and amortized spreads within an
overlapping-generations economy. In equilibrium, our parsimonious crosssectional equation explains expected returns by three components: the zerobeta rate that includes both the risk-free rate and the market-average
expected amortized spread; the market risk premium that incorporates compensations for both fundamental and spread risks; and the asset-specic
term that captures the dierence between the expected amortized spread
of a given asset and that of the market portfolio. To reect the evidence of
systematic liquidity directly, we impose a liquidity factor structure on the
expected amortized spread. Our cross-sectional equation with the embedded liquidity factor explicitly indicates the co-existence of two eects of
the amortized spread: the level eect (static channel) that views the amortized spread as an asset characteristic; and an incremental sensitivity eect
(dynamic channel) that views the amortized spread as a risk factor.
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The primary focus of our empirical examination is on cross-sectional tests

of the level and sensitivity eects of the amortized spread. We form 25 sizespread portfolios following the approach of Fama and French (1992) using
monthly data for a large cross section of Canadian stocks from April 1977 to
December 2002. To perform these cross-sectional tests, we use pooled crosssection and time series GLS regressions, and we test the level and sensitivity
eects with a variety of control variables. We nd evidence that the level
and sensitivity eects of the amortized spread are present in our whole test
period. This suggests that investors not only command higher compensation
for stocks with higher levels of trading costs, but that they also demand an
incremental risk premium for stocks that are more sensitive to broad liquidity shocks. We also examine the two eects over two sub-periods and nd
an intertemporal shift in the relative importance of the level and sensitivity
eects. The level eect dominates the sensitivity eect during the rst subperiod, while the sensitivity eect is more prominent and signicant during
the second sub-period. This implies that when facing both a higher level
and higher volatility of transaction costs that are induced by more active
trading, investors seem to care more about an assets sensitivity to marketwide liquidity factors than the level of transaction costs. This nding is
consistent with the information-trading hypothesis of Wilcox (1993), which
relates trading strategies with the value and rate of decay of information
held by the representative investor. Our results are robust across dierent
sets of control variables and are not the artifact of the well-documented
seasonal behavior of liquidity. With regard to the control variables, we nd
that conditional betas (i.e., conditioning on up- or down-markets as in Pettengill, Sundaram and Mathur, 1995) can explain the negative beta-return
relation that is observed when the unconditional beta is used. Furthermore,
counter to the literature (e.g., Scruggs and Glabadanidis, 2003; Chalmers
and Kadlec, 1998), we nd a signicantly positive return-volatility relation,
which subsumes the beta eect during up-markets and much of the size
eect.
We also empirically examine the time-series behaviors of the marketaverage amortized spreads. Preliminary evidence shows that the marketaverage amortized spread becomes increasingly important over time, both
in determining the level and volatility of average trading costs, and in inuencing the equilibrium zero-beta rate. Furthermore, we nd that the increase
in the level and volatility of the amortized spread during the late 1990s is
mainly due to increased trading activities rather than to a widening of the
proportional eective spread.
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Our paper extends the study of Chalmers and Kadlec (1998) who conduct
the rst empirical examination of amortized spreads. Chalmers and Kadlec
(1998) test the level eect alone of the amortized spread for US stocks during 1983 to 1992 and nd weak evidence for a level eect. In comparison,
we jointly test both the level and sensitivity eects for a longer period (i.e.,
19822002) and nd that the two eects are present, and that the relative
importance of the two eects diers for dierent time periods. Pastor and
Stambaugh (2003) examine the sensitivity eect of asset returns to liquidity risk for the US stock market over the period between 1965 and 1998.
Using volume-related return reversals to construct an aggregate illiquidity
measure, Pastor and Stambaugh (2003) nd that the sensitivities of returns
to uctuations in aggregate liquidity command a signicant risk premium.
However, Pastor and Stambaugh (2003) do not control for the level eect
of illiquidity, whereas we examine the joint eect and nd that both eects
are signicant.
Our paper is most closely related to the study of Acharya and Pedersen
(2005) who develop a liquidity-adjusted CAPM and examine three sources of
liquidity risk on the monthly returns of US stocks between 1964 and 1999. It
is important to highlight dierent model construction, illiquidity measures,
and therefore empirical results between our study and theirs. Also in an overlapping generations economy, Acharya and Pedersen (2005) attribute liquidity risk to three sources of liquidity betas: cov(Lj , Lm ), which is the covariation between an assets illiquidity and the markets illiquidity; cov(Rj , Lm ),
which is the covariation between an assets return and the markets illiquidity; and cov(Lj , Rm ), which is the covariation between an assets illiquidity
and the market return. Using a calibrated measure of illiquidity proposed by
Amihud (2002), Acharya and Pedersen (2005) nd that the commonality of
liquidity, as captured by cov(Lj , Lm ), is not important in asset pricing. However, this nding is limited by their model restriction that the three sources
of liquidity risk have the same risk premium in order to side step the severe
co-linearity problem that occurs when the three liquidity betas are jointly
estimated. The nding may not hold if cov(Lj , Lm ) bears a higher premium.
In contrast, we develop a cross-sectional model under a mild and widely
adopted assumption (i.e., Amihud, 2002) that the rms cash ow process is
uncorrelated with liquidity shocks. Thus, our model focuses on the relative
importance between the level and commonality of liquidity without the colinearity problem induced by cov(Rj , Lm ) and cov(Lj , Rm ). In terms of the
illiquidity measure, unlike Acharya and Pedersen (2005) who use an empirically calibrated illiquidity measure, the amortized spread used in our study
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is a direct illiquidity measure that is theoretically grounded (Amihud and

Mendelson, 1986) and empirically supported (Chalmers and Kadlec, 1998).
Furthermore, unlike the ndings of Acharya and Pedersen (2005), our empirical results suggest that cov(Lj , Lm ) plays an important asset-pricing role
beyond that contained in the level of illiquidity. Furthermore, our subperiod analysis nds a predominant asset-pricing role for cov(Lj , Lm ) after the
early 1990s. The dierent results obtained by Acharya and Pedersen may
be attributed to dierences in model assumptions, illiquidity measures, and
the studied nancial markets.
The remainder of this paper is organized as follows. Section 2 sets up
the economy and denes the amortized spread. Section 3 formally derives
the cross-sectional model in equilibrium. In Section 4, we impose a factor
structure on the amortized spread and discuss the various asset-pricing channels of the amortized spread. Section 5 describes the data and measures for
empirical examination. Section 6 explains the estimation and testing procedures, and presents and discusses the test results. In Section 7, we provide
concluding remarks.
2. The Amortized Spread
The initial setup of our economy is based on the static economy of Amihud
and Mendelson (1986). Consider I investor types (i = 1, . . . , I) who invest
and trade J risky assets (j = 1, . . . , J) and one risk-free asset. Each risky
asset j, with a market capitalization denoted by Vj , pays out a random cash
ow dj per unit of time. The round-trip trading cost for risky asset j is
measured by a random proportional spread sj per unit of time. The trading
cost for the risk-free asset is zero. Each investor-type i holds his assets for a
randomly distributed time with mean E[Ti ] = 1/i . In other words, i is the
expected turnover rate for investor-type i. Under such an economic setup,
the return-spread relation is developed (Amihud and Mendelson, 1986) as
the following:
j i sj ,
rij = dj /Vj i sj = R
(1)
where rij is the spread-adjusted (i.e., net) return of asset j to investor-type

j dj /Vj is the fundamental (gross) return on asset j,
i per unit of time, R
and i sj is the spread-adjustment, or liquidation cost of asset j to investortype i.
The above equation is the same as Eq. (4) of Amihud and Mendelson (1986, p. 227), except that the proportional spread is modeled as a
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random process instead of a deterministic term. The random spread sj

reects the recently documented evidence of systematic liquidity, and it
intends to capture the sensitivity eect of illiquidity in a cross section.
The clientele eect of liquidity hypothesizes that assets with higher
expected proportional spreads E[
sj ] are held by investors who plan a longer
holding period 1/i (a lower turnover i ). Thus, the expected return of an
asset can be related to its proportional spread without observing dierent
investor types, i.e., the return-spread relation is an increasing and concave
piecewise-linear function. However, because the return-spread relation in
Eq. (1) is prescribed for a given investor clientele i, it does not tell us how
asset returns are on average related to spreads, i.e., when averaged across
the dierent holding periods of investors. Since this issue remains largely
unresolved, we hereby take a dierent route to examine the cross-sectional
relation of returns and spreads. Instead of prescribing the clientele eect or
observing dierent investor types, we aggregate across all investor types to
form a market-average expected turnover that reects the view of a representative investor. Formally, let wij denote the proportional wealth invested
in rm j by investor type i. For each risky asset j, we aggregate across
investor-type i from 1 to I and obtain:
j
R

i
wij rij =

i
j
wij R
j j sj ,
wij i sj = R
j = 1, . . . J (2)1
wij rij is a weighted average net return of

In the above equation, R
j
i
asset j, with the weight given by investor is proportional wealth invested in
j stems from the aggregation condition wij = 1.2
j = wij R
asset j. R
i
i

j
w
is
the
expected
turnover
rate
of
asset
j
for
an
average
or
ij
i
i
representative investor. In Eq. (2), j sj is the expected turnover multiplied
by the proportional spread of asset j. Chalmers and Kadlec (1998) interpret
this product as the amortized spread of asset j, and they argue that the
amortized spread is more relevant than the proportional spread in asset
pricing.
1
Equation (2) follows the intuition of Atkins and Dyl (1997). The authors argue that
the hypothetical average investor is an appropriate construct to investigate the relation
between transaction costs and the time horizon of investors, which is the reciprocal of the
turnover rate.
2
Given the denition of wij , if we aggregate across all the investor types (over i) for the
proportional wealth
Pinvested in rm j, the total market proportional wealth on rm j must
sum to unity, i.e., i wij = 1. This is referred to as the aggregation condition.
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To proceed, we use the denitions of expected turnover (j ) and proportional spread (

sj ) to obtain:
j sj =
sdj
vj
Sj
m =
Sja ,
nj
pj
Vj
(3)
where vj is the expected share volume of asset j for the next unit period,
nj is total number of shares outstanding of rm j, sdj is the random dollar
spread per share for the next unit period, pm
j is the bid-ask midpoint, which
is used as the observed share price of asset j, Sj vj sdj is the total spread
of trading asset j, and Vj nj pm
j is the observed market capitalization
of rm j.
From Eq. (3), the amortized spread of the jth asset Sja is equivalently
dened as the assets total spread (as a proxy for the total trading costs
of the asset per unit of time) divided by the assets market capitalization.3
Substituting Sja into Eq. (2) yields:
j Sa .
= R
R
j
j
(4)
Thus, the net return of asset j is the fundamental (gross) return net of its
amortized spread.
3. A Cross-Sectional Model of Expected Returns
and Amortized Spreads
In this section, we develop a capital market equilibrium within a static
economy as illustrated in the previous section. The trading motive of our
model can be illustrated by an overlapping-generations economy in which a
representative agent lives for one period from t to t + 1.4 The agent has an
initial endowment W , with which he acquires J risky assets (j = 1, . . ., J)
and one risk-free asset at time t. At the end of the period (i.e., t + 1), the
agent sells all his assets to the representative agent of his next generation
and derives utility from consumption.
3
Following Chalmers and Kadlec (1998), this denition of the amortized spread is implemented in our empirical examination.
4
The overlapping-generations economy has been used to motivate trades in the economy
of Acharya and Pederson (2005). According to the authors, the overlapping-generations
economy is a valid assumption to capture the large turnover observed in markets such as
the Canadian market studied herein.
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The return from holding the risk-free asset is the market observed riskfree rate denoted by Rf . The amortized spread for the risk-free asset is zero.5
The fundamental (gross) return from holding the jth asset is given by:
j ] + j ,
j = E[R
R
(5)
j ] is the assets expected gross return to be determined in equiwhere E[R

librium and j N (0, j2 ) is the random shock to the fundamental return
process that follows a normal distribution.
In addition, the dollar spread process (Sj sdj vj ) for the jth asset is
given by:
j ] + j ),
Sj = Sj (E[L
(6)
where
Sj sdj vj is the currently observed total dollar spread for asset j,
j Sj /Sj is asset js spread ratio that measures the proportional
L
increase or decrease in dollar spread for the next unit period,
j ] is the assets expected spread ratio to be specied by a liquidity
E[L
factor model, and
j N (0, 2j ) is the random shock to the spread ratio process that
follows a normal distribution.
For any given asset j, we assume that the fundamental return process is
j ) = 0. This
j , L
uncorrelated with the spread ratio process, such that cov(R
assumption is adopted in the literature under a variety of economic settings.
In Amihud and Mendelson (1986), investors trade for liquidity rather than
informational reasons. Another source of systematic liquidity may be due to
a revolutionary market-making technology that systematically facilitates the
trading process. For example, Barber and Odean (2002) report that, other
things being equal, the on-line market-making technology induces more trading activities. A market-wide shock induced by liquidity and technological
reasons is likely not to be correlated with the return-generating process that
drives corporate cash ows. Furthermore, Amihud (2002) explicitly makes
this assumption in his investigation of the return-illiquidity relation.6
5
This assumption reects the common observation that the treasury market is much more
liquid than the stock market (Amihud, 2002).
6
The assumption that the return process and the spread process are uncorrelated is necessary to derive the separate roles of the level and sensitivity eects of liquidity in our model.
However, other studies indicate that the two processes may be correlated. For example,
Baker and Stein (2004) nd that liquidity can be used as a sentiment indicator given
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Given the above specications, the portfolio problem of the representative agent is to consider both the fundamental value and trading costs of
rms. At each unit of trading interval, the agent optimally allocates assets by
taking both dimensions into his portfolio decision. If the amortized spread is
an important consideration for the agent to choose his optimal portfolio, he
will rationally require higher compensations for holding stocks with higher
levels of amortized spread (the level eect), as well as for stocks with higher
sensitivity to market-wide liquidity shocks (the sensitivity eect). These two
components of compensation are reected in the equilibrium gross return of
a given asset.
be the representative agents random wealth at the end of the
Let W
is determined by the dollar return on the risk-free asset,
unit period. W
plus the net dollar return on the risky portfolio. Specically,

,
Wj Rf +
Wj R
(7)
W = W
j
j
where
W is the total wealth (dollar) of the representative agent at the beginning of the period,
Wj is the dollar amount invested in the jth asset, and
j Sa is given by Eq. (4).
= R
R
j
j
The representative agents objective is to maximize the expected utility
derived from his end-of-period wealth, i.e.,
Max
{Wj }
)].
E[U (W
(8)
The solution of the agents portfolio problem within the static market equilibrium framework is provided in the appendix. The derivations of the solution are in the spirit of Fama (1976, Ch. 8) and Merton (1987). Our main
results are presented as follows:
m ] Rz ) + (E[Sa ] E[Sa ]) ,
j ] = Rz + w (E[R
E[R
j
j
m
(9)
the existence of a class of irrational investors that boost liquidity and can dominate the
market. To the extent that the assumption does not hold, the empirical results presented
in this paper on the separate roles of the two liquidity eects should be interpreted with
caution.
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where
a ] is interpreted as the market equilibrium zero-beta
Rz Rf + E[Sm
rate;
(9.1)
jw v jv + s js is the weighted average of the fundamental and

spread betas;
(9.2)
j , R
m ]/var[R
m ] is the fundamental beta;
jv cov[R
(9.3)
a ]/var[S
a ] is the spread beta;
js cov[Sja , Sm
m
(9.4)
m ]/(var[R
m ] + var[Sa ]) is the proportional weight of the
v var[R
m
fundamental beta;
a ]/(var[R
a ]) is the proportional weight of the
m ] + var[Sm
s var[Sm
spread beta;
(9.5)
(9.6)
a ] are the expected amortized spreads of asset j and the

E[Sja ] and E[Sm
market portfolio, respectively; and
Rf is the market observed risk-free rate.

Given the above denitions, the following proposition explains an assets
expected (gross) return.
Proposition 1. An assets equilibrium (gross) return is composed of the
following three components:
(i) A zero-beta rate that captures both the risk-free rate and the marketaverage expected amortized spread;
(ii) A market risk premium that incorporates compensations for both fundamental and spread risks, with the sensitivity given by the fundamental
and spread betas, and the proportion of the premiums given by the relative variance between these two types of risks; and
(iii) An asset-specic term that is measured by the deviation of an assets
expected amortized spread from the market-average expected amortized
spread.
Since Rz collects all the market-related terms, it is termed the equilibrium zero-beta rate. The rst component of Rz is the market-observed
risk-free rate Rf . The second component captures the expectation of the
market-average amortized spread. Hence, this endogeneous component is a
zero-beta premium that compensates for the expected adverse investment
environment that reduces the overall wealth due to higher trading costs.
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When the representative agent expects an overall deteriorating liquidity condition as measured by a widening amortized spread, this investor responds
by increasing the zero-beta rate such that all the assets in the economy earn
higher illiquidity premia.
The second part of Proposition 1 shows that the cross-sectional model
preserves the risk-return relation as prescribed by the zero-beta version of
the CAPM (Black, 1972). One distinctive feature of our model is that the
beta is a weighted average of the fundamental beta and the spread beta
(as dened in Eqs. 9.3 and 9.4, respectively), with the weights given by
the proportional variance of the fundamental return (as dened in Eq. 9.5)
and the proportional variance of the spread ratio (as dened in Eq. 9.6)
for the market portfolio. Whether the fundamental beta or spread beta has
more weight in the determination of the weighted average beta is an issue
to be examined empirically. If we combine the weights with the market risk
m ]Rz ) and s (E[R
m ]Rz ) then reppremium, the combined terms v (E[R
resent the compensation for fundamental risk and spread risk, respectively.
Hence, we can empirically assess the relative importance of their respective premiums by examining their respective proportional variances (i.e., v
versus s ).
With regard to the third part of the proposition, Eq. (9) indicates that
the asset-specic term is determined cross-sectionally by the deviation of
the assets expected amortized spread from that of the market portfolio.
A rm earns a higher (lower) spread premium if its amortized spread is
expected to be higher (lower) than the market-average amortized spread. A
rm with the market-average expected amortized spread requires no additional spread premium. Thus, the asset-specic term of Eq. (9) formalizes the
intuition of Sharpe (1984) for an extended CAPM where assets with higher
(lower) liquidity earn lower (higher) expected returns. The implications of
the expected amortized spread are formally examined in the following section of the paper.
4. A Factor Model of the Amortized Spread
To reect the evidence of systematic liquidity reported in the literature (discussed earlier), we formally impose a factor structure on the expected amortized spread term E[Sja ]. With no loss of generality, consider the following
one-factor model on the spread ratio process given by Eq. (6):
j ] + jl Y + j ,
j Sj /Sj = E[L
L
(10)
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where
Y denotes a market-wide liquidity factor that follows a normal distribution Y N (0, 2 ),
j is the idiosyncratic risk of the spread ratio with E[j |Y ] = 0 and
cov(j , j ) = 0 when j = j , and
j , Y )/var(Y ) is interpreted as the liquidity beta that meajl cov(L
j to the common liquidity
sures the sensitivity of asset js spread ratio L
factor Y .
j ], consider forming a zeroTo establish the expected spread ratio E[L
cost portfolio of assets with the same level of market risk but with dierent
spread ratios Lj (j = 1, . . ., J). If the zero-cost portfolio has zero sensitivity
to the common liquidity factor Y and is diversied of idiosyncratic risk
j , then the expected spread ratio for that portfolio must be zero, which
implies:
j ] = 0 + jl 1 ,
E[L
(11)
where
0 is the zero-beta illiquidity premium and
1 is the risk premium for the common liquidity factor.
Then, from Eqs. (10) and (11), we have
E[Sj ] = Sj (0 + jl 1 )
l
1 ),
E[Sm ] = Sm (0 + m
(12)
(13)
l is the sensitivity of the spread ratio of the market portfolio

where m
to the common liquidity factor. In the special case where the common
liquidity factor happens to be the spread ratio of the market portfolio,
l = 1.
m
Plugging Eqs. (12) and (13) into Eq. (9) and using the substitutions
a
a S /V yields the following result:
Sj Sj /Vj and Sm
m
m
a
a l
m ] Rz ) + (Sja Sm
j ] = Rz + jw (E[R
)0 + (Sja jl Sm
m )1 , (14)
E[R
where
l
a
1 )Sm
.
Rz Rf + (0 + m
(15)
Unlike the concave relation between expected returns and proportional

spreads as developed in Amihud and Mendelson (1986), Eq. (14) suggests
that the expected return of an asset is linearly related to its amortized
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spread. The last two terms of Eq. (14) explicitly indicate the co-existence of
two eects of the amortized spread on expected returns. Specically, the 0
term measures the level eect that views the observed amortized spread Sja
as an asset characteristic. The reason is that the level eect is free of both
fundamental risk and liquidity risk by the construction of 0 in Eq. (11), and
the level eect measures the zero-beta illiquidity premium. The loadings on
0 are determined by the deviation of an assets observed amortized spread
from the market-average amortized spread. Assets with above- (below-) average amortized spreads require higher (lower) equilibrium returns. Furthermore, the amortized spread can be viewed as containing an incremental risk
component as captured by the 1 term in Eq. (14). Observe that the loading
on 1 is jointly determined by the amortized spread level Sja and the spread
beta jl . At a given level of amortized spread (i.e., xing Sja ), the illiquidity risk premium 1 is solely attributable to the cross-sectional variation in
spread betas. Thus, assets with higher sensitivity to market-wide liquidity
shocks require risk premia that are beyond the premia for the given level of
illiquidity.
To summarize, a re-examination of Eqs. (14) and (15) reveals that the
amortized spread may aect an assets equilibrium return through four channels as given by the following proposition:
Proposition 2.
(i) Both the level (0 ) and sensitivity (1 ) eects of the overall market inuence the equilibrium zero-beta rate, which, in turn, aects the required
returns of all the assets in the economy
(ii) The spread beta (js ) of a given asset exerts its pricing role through an
embedded weighted component of the total beta (jw ), where its weight
determines the relative importance of the spread premium in the market
risk premium
(iii) The level eect aects the assets expected return through the zero-beta
illiquidity premium (0 )
(iv) At a given level of the amortized spread (i.e., at a xed Sja ), the sensitivity eect plays an incremental pricing role through the illiquidity risk
premium (1 ).
In the next section of this paper, we empirically examine the importance of the above four channels using a large cross section of Canadian
stock market data. For Channel 1, we report the market-average amortized
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spread across our entire sample period (26 years) and two equal-length subperiods. We present evidence that the amortized spread plays an increasingly
important pricing role over time, both in determining the level and volatility of market-average trading costs and as a component of the equilibrium
zero-beta rate. For Channel 2, we examine the proportional variance of v
relative to s in order to test whether the fundamental beta jv or the spread
beta js is the dominant component in the weighted average beta jw . Since
we nd that Channel 2 is not very important, our primary focus is on crosssectional tests of Channels 3 and 4. If both the level and sensitivity eects
are important, we expect their respective premia 0 and 1 to be signicantly positive. Furthermore, we examine the estimates and signicance of
0 and 1 in two sub-samples and test the relative importance of 0 and 1
across the two equal-length sub-periods.
5. Data Description
In the empirical part of our research, we dene the unit of trading interval as
one month. Therefore, we examine monthly data on common stocks listed in
the CFMRC database from April 1977 to December 2002, for a total of 309
time series observations.7 Compiled by the University of Western Ontario
and the TSX, the CFMRC for Canadian stocks is analogous to the CRSP
for US stocks. The primary advantage of using the CFMRC is that the
dataset is, relatively speaking, free of the well-known data-snooping biases
(Lo and MacKinlay, 1990). While the spread-return relation in the US stock
markets has been under investigation for at least the past two decades,
relatively little testing of such an important relation has been conducted
for the well-developed Canadian stock market. Therefore, ndings from this
relatively fresh dataset regarding the spread-return relation are less likely
to be spurious.
The monthly database of the CFMRC records monthly prices, returns,
betas, shares outstanding, share volume, and dividends for stocks listed on
the Toronto Stock Exchange (TSX) since January 1950. The daily database
contains the transaction prices, closing bid and closing ask quotes of listed
stocks for each trading day starting from March 1, 1977. From the daily
database, we extract the month-end closing bid and ask quotes for each
stock that passes through a screening process that controls for data errors,
7
Chalmers and Kadlec (1998) examine the amortized spread for US stocks for a shorter
time period, i.e., 19831992.
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adjusts for thin trading, and removes stale and invalid quotes. Furthermore,
rms with market values below CAD $5 million or rms with a market
price per share less than CAD $2 are deleted from further analysis. We then
match the month-end bid and ask quotes from the daily database with the
monthly shares outstanding and share volume for each selected stock. Our
data collection process results in a total of 309 cross sections from April
1977 to December 2002, with the monthly number of records ranging from
331 to 769 for each cross-section.
For each stock j at month t, its fundamental return is computed from the
m
closing bid-ask midpoints of consecutive months, i.e., Rjt = (pm
jt pjt1 +
m
djt )/pm
jt1 , where pjt is the bid-ask midpoint and djt is the cash or cash equivalent dividend paid during month t for stock j. Due to the well-documented
serial correlation in the time series of transaction prices (e.g., Roll, 1984),
we do not take the database-provided returns that are transaction price
based. For the purpose of this study, it is important to isolate the eect
of fundamental returns from that of amortized spreads. Since transaction
prices may be contaminated by the spurious correlation induced by bidask bounce, these two eects are intermingled when traded price returns
are used. Because the midpoints of bid-ask spreads are free from bid-ask
bounce, our calculated fundamental returns based on bid-ask midpoints are
free from the spurious correlation caused by bid-ask bounce.
For each stock j at month t, we calculate the eective spread as sdjt
m
2 |pjt pm
jt |, where pjt and pjt are respectively the transaction price and
bid-ask midpoint.8 The total spread of trading stock j at month t is then
calculated as the product of the eective spread (sdjt ) and the number of
shares traded (vjt ), i.e., Sjt sdjt vjt .9 Intuitively, Sjt roughly measures
the total amount of transaction fees paid to making the market for rm j
during the month t. Accordingly, the proportional change in the spread cost
is computed as Ljt (Sjt Sjt1 )/Sjt1 , which measures the proportional
change of total trading costs from month to month. Given the Ljt series, we
estimate the liquidity beta of asset j or jl by regressing Ljt on Lmt , where
Lmt is the proportional change in spread costs of the market portfolio.
This is consistent with Chalmers and Kadlec (1998). They use the eective spread instead
of quoted bid-ask spread to calculate the amortized spread. The superscript of sdjt indicates
that the eective spread is in dollar terms.
9
As a robustness check, we also calculate the eective spread on a daily basis then sum
up the values over the month to obtain the monthly eective spread. Doing such does not
have a material impact on our empirical results.
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For each stock j at month t, the market value is computed as Vjt

njt, where pm
jt is the bid-ask midpoint and njt is the number of shares
outstanding. Having dened Sjt and Vjt , the amortized spread is the ratio
a S /V . Thus, in our empirical implementation of
of the two, i.e., Sjt
jt
jt
a
Eq. (14), we use Sj to proxy the level of the amortized spread, and Sja jl to
proxy the sensitivity of the amortized spread.
At each month t, the above measures for the market portfolio are taken
as the equally weighted cross-sectional means, following the approach of
Amihud (2002), Chalmers and Kadlec (1998), and Chordia, Roll and Subrahmanyam (2000). Similarly, the above measures for any constructed portfolios are computed by taking the cross sectional means at each month t.
For the risk-free rate, we convert the 90-day Canadian Treasury bill series
into a 30-day series for the same period.
pm
jt
6. Empirical Procedures and Test Results

6.1. The amortized spread of the market portfolio
Table 1 reports the time series statistics for the market portfolio that is constructed by taking the cross-sectional averages of the investigated variables.
a and its relations with
Our primary focus is on the amortized spread Sm
the other variables. Consistent with the ndings of Chalmers and Kadlec
(1998), the magnitude of the market-average amortized spread is small.
From Table 1, the monthly average amortized spread for our whole sample
is 0.0651%, annualized to 0.78%, of equity value. This percentage is higher
than but comparable to the annualized amortized spread of 0.5% for the US
stock market for the time period (i.e., 19831992) examined by Chalmers
and Kadlec (1998).
We also divide our sample time period into two equal halves (1977:04
1989:12 and 1990:012002:12), and compute the same time series statistics
for each half. The market amortized spread exhibits in its own scale a significantly higher level and volatility in the second sub-period. From Table 1, we
observe that the average annualized amortized spread increases from 0.62%
(i.e., 0.0516% 12) in the rst sub-period to 0.94% (i.e., 0.0782% 12) in
the second sub-period, and that its standard deviation increases by more
than 50% (i.e., from 2.19% to 3.36%). The increase in the level and volatility of the amortized spread is intuitively more evident from an examination
of Fig. 1, where the time series of the cross-sectionally averaged amortized
spread is plotted.
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Table 1.
Time series statistics for the market portfolio.
This table reports the time series statistics (mean, median, standard deviation, 5% percentile, 95% percentile, proportional variance) for the investigated variables of the market
portfolio. The market portfolio is constructed by taking the equal-weighted average of all
the eligible stocks for each month. Panels AC report the statistics for the whole sample period (1977:042002:12), rst sub-period (1977:041989:12), and second sub-period
a
is the amortized spread of the market portfolio, con(1990:012002:12), respectively. Sm
structed by taking the cross-sectional mean of the amortized spreads of the individual
stocks. A stocks amortized spread is estimated as the product of the eective spread and
share volume divided by the market capitalization. Rm is the fundamental (raw) return
of the market portfolio, constructed by taking the cross-sectional mean of the raw returns
of the individual stocks. Rf is the risk-free rate, converted from 90-day Canadian T-bill
rates. ProSpd is the proportional eective spread of the market portfolio, constructed
by taking the cross-sectional mean of the proportional eective spreads of the individual
stocks. Turnover is the turnover rate of the market portfolio, constructed by taking the
cross-sectional mean of the turnovers of the individual stocks. The proportional variance
a
]); and the proportional variance for
for Rm is given by v var[Rm ]/(var[Rm ] + var[Sm
a
a
a
is given by s var[Sm
]/(var[Rm ] + var[Sm
]).
Sm
Variable
Mean
5% Pct.
95% Pct.
Prop. Var.
Panel A: Whole time period: 1977:042002:12

a
(100)
6.51%
5.74%
3.14%
Sm
1.27%
1.52%
5.18%
Rm
0.69%
0.69%
0.32%
Rf
ProSpd
2.38%
2.28%
0.46%
Turnover
3.53%
3.07%
1.76%
3.57%
6.65%
0.21%
1.86%
1.63%
11.92%
8.58%
1.23%
3.33%
6.62%
< 0.1%
> 99.9%
Panel B: First
a
(100)
Sm
Rm
Rf
ProSpd
Turnover
1977:041989:12
4.72%
2.19%
1.61%
5.79%
0.86%
0.25%
2.27%
0.56%
2.43%
0.83%
3.19%
7.21%
0.56%
1.86%
1.40%
8.82%
10.72%
1.41%
3.55%
3.87%
< 0.1%
> 99.9%
Panel C: Second sub-period: 1990:012002:12

a
(100)
7.82%
7.20%
3.36%
Sm
0.97%
1.33%
4.52%
Rm
0.48%
0.41%
0.22%
Rf
ProSpd
2.32%
2.29%
0.34%
Turnover
4.51%
4.33%
1.86%
3.92%
6.02%
0.16%
1.90%
2.08%
13.92%
7.01%
1.04%
2.89%
7.32%
< 0.1%
> 99.9%
sub-period:
5.16%
1.59%
0.91%
2.43%
2.52%
Median
Std. Dev.
Since the amortized spread is jointly determined by the proportional

eective spread (as a measure for unit transaction costs) and turnover rate
(as a proxy for trading activities), we investigate whether the increase in the
amortized spread over time is due to a higher turnover rate or to a widening
of the proportional spread. The result is plotted in Fig. 2, where the proportional eective spread (the dashed line) remains fairly steady across the
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0.25%
0.20%
0.15%
0.05%
0206
0103
9912
9809
9706
9603
9412
9309
9206
9103
8912
8809
8706
8603
8412
8309
8204
8101
7910
7807
0.00%
7704
0.10%
This gure plots the amortized spread of the market portfolio at a monthly frequency over
a
)
the period from 1977:04 to 2002:12. The amortized spread of the market portfolio (Smt
is computed by taking the cross-sectional mean of the amortized spreads for all eligible
a
) for each month. A stocks amortized spread is estimated as the product of the
stocks (Sit
eective spread and share volume divided by its market capitalization.
Fig. 1.
Monthly amortized spread of the market portfolio (1977:042002:12).
whole period, whereas the turnover rate (the solid line) experiences a dramatic increase in both its level and variability during the second sub-period.
Quantitatively, we nd from Table 1 that the monthly proportional spread
drops, on average, by 11 basis point (from 2.43% to 2.32%) and the standard deviation decreases by 22 basis points (from 0.56% to 0.34%) during
the second sub-period. These gures indicate a signicant decrease in both
the level and volatility of the unit transaction costs during the second subperiod. On the other hand, the average turnover rate increases to 4.51% in
the second sub-period from 2.52% in the rst sub-period, and the standard
deviation more than doubles (from 0.83% to 1.86%). Our ndings suggest
that it is the increase in trading activities rather than in unit transaction
costs that have caused the intertemporal increase in the market-average
amortized spread.
In addition, our model (i.e., Eq. 9) predicts that the equilibrium zerobeta rate Rz is composed of the risk-free rate Rf and the market expected
a ]. We now investigate the relative importance of the
amortized spread E[Sm
realized amortized spread of the market portfolio compared to the observed
risk-free rate. We calculate the ratio of these two components over time
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12%
10%
8%
6%
2%
0205
0104
0003
9902
9801
9612
9511
9410
9309
9208
9107
9006
8905
8804
8703
8602
8501
8312
8209
8108
8007
7906
7805
0%
7704
4%
This gure plots the proportional eective spread and turnover rate of the market portfolio
at a monthly frequency over the period from 1977:04 to 2002:12. The solid line plots the
turnover rate of the market portfolio, which is computed by taking the cross-sectional
mean of the turnover rates for all eligible stocks for each month. The dashed line plots
the proportional eective spread of the market portfolio, which is computed by taking the
cross-sectional mean of the proportional eective spreads for all eligible stocks for each
month.
Fig. 2. Monthly eective spread and turnover rate of the market portfolio (1977:04
2002:12).
a /R ). To do so, we convert the 90-day T-bill rate to proxy for

(i.e., Smt
ft
a by taking the cross-sectional mean of the amortized
Rf t and obtain Smt
spread for all eligible stocks at month t. The time series behavior of the
ratio is plotted in Fig. 3. We observe a generally increasing trend for the
ratio over time, which suggests that the market-average amortized spread
plays an increasingly important role in the equilibrium zero-beta rate during
the later period of our sample.
The preliminary evidence of our time series analysis suggests that the
market-average amortized spread seems to exert an increasingly important
role in expected returns, both in determining the level and volatility of
market-average trading costs and in inuencing the equilibrium zero-beta
rate. Furthermore, we nd that it is the increase in trading activities rather
than a widening in the proportional spread that causes the increase in the
amortized spread over time.
Table 1 also reports a test of the asset-pricing role of the spread beta.
According to the second channel as described in Proposition 2, we test
the relative signicance between the fundamental and the spread betas by
December 22, 2006
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70%
60%
50%
40%
30%
20%
0206
0103
9912
9809
9706
9603
9412
9309
9206
9103
8912
8809
8706
8603
8412
8309
8204
8101
7910
7807
0%
7704
10%
This gure plots the ratio (in percentage) of the market-average amortized spread to the
market observed risk-free rate at a monthly frequency over the period from 1977:04 to
a
) is computed by taking the cross2002:12. The market-average amortized spread (Smt
a
sectional mean of the amortized spreads (Sit ) of all the eligible stocks at a monthly
frequency. A stocks amortized spread is estimated as the product of the eective spread
and share volume divided by its market capitalization. The monthly risk-free rate (Rf t )
is converted from the Canadian 90-day T-bill rate.
Fig. 3. Monthly ratio of the market average amortized spread to the market observed
risk-free rate.
examining their proportional weights (v and s ). The proportional variance

column in Table 1 indicates that the variance of the fundamental returns
(whose weight is more than 99.9%) completely dominates the variance of
the market-average amortized spread (whose weight is less than 0.1%). This
evidence infers that the fundamental beta jv is the predominant component
of the weighted average beta jw , and that the impact of the spread beta
js is negligible. Because the time series of amortized spreads is of a much
smaller scale (as measured by its proportional weight) relative to the fundamental return time series, the systematic component of the amortized
spread is unlikely to have a signicant role in determining the market risk
premium.
6.2. Cross-sectional tests of the amortized spread
The relation between stock returns, fundamental betas, and amortized
spreads is tested over the period 1977:04 to 2002:12. The main testable
hypothesis is that a level eect and sensitivity eect exists in the amortized spread. Following the two-step portfolio approach developed by Fama
and MacBeth (1973), we divide our data into portfolio formation period,
portfolio estimation period, and cross-sectional test period.
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00087.tex
Fama and French (1992) nd that the beta eect is highly correlated
with the size eect. Elfakhani, Lockwood and Zaher (1998) nd that beta
does not explain returns for Canadian stocks after controlling for rm size.
Thus, in the portfolio formation stage, we rst sort stocks into ve size
portfolios in December of each year starting from 1974. Within each of the
ve size portfolios, we further classify rms into one of ve sub-portfolios
on the basis of the amortized spreads of the rms.10 These 5 5 size-spread
portfolios are constructed at the end of each year T , where T = 1977 to
2001. For each of the twelve months in year T + 1, we assign each rm
to one of the 25 portfolios formed at the end of the previous year. We then
compute equal-weighted fundamental returns Rit , market capitalizations Vit ,
amortized spreads Sita , and proportional changes in spreads Lit for portfolio i
at month t. Finally, we subtract the proxy of the zero-beta rate from portfolio
e
is raw return to obtain the excess return of the portfolio. Specically, Rit
a
Rit Rzt, where Rzt Rf t + Smt , Rf t is obtained from the Canadian T-bill
a is the cross-sectional mean of the amortized spread for all
series, and Smt
the eligible stocks at month t.
In the portfolio estimation stage, the fundamental beta iv (dened in Eq.
9.3) and the liquidity beta il (dened in Eq. 9.4) are estimated for portfolio
i. We use Rmt to proxy for the market portfolio fundamental return, and Lmt
to proxy for the realization of the common liquidity factor. In doing so, we
assume that the spread ratio of the market portfolio is the single underlying
liquidity factor. Following the approach of Fama and French (1992), we estimate each portfolios fundamental beta and liquidity beta using 60-month
time series regressions. Specically, in December of each year T , T = 1981
to 2001, we run the following time series regression for each portfolio i:
e
e
= + iv Rmt
+ it ,
Rit
Lit = + il Lmt + it ,
t = 1, . . . , 60
(16.1)
t = 1, . . . , 60,
(16.2)
where
e R R and Re R
Rit
it
zt
mt Rzt are the excess return for portfolio
mt
i and the market portfolio, respectively, and
Lit and Lmt are the cross-sectional mean of Ljt (Sjt Sjt1 )/Sjt1
for portfolio i and the market portfolio, respectively.
10
The double-sort procedure is due to Amihud and Mendelson (1986) in their test of
the spread-return relation. Since rm size and amortized spread tend to be negatively
correlated, controlling for rm size ensures that our ndings on the amortized spread are
not due to the well-documented size eect.
December 22, 2006
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00087.tex
The estimates iv and il are used for portfolio i in year T + 1 up to

year 2001. At the end of the estimation stage, we have a test dataset of 25
cross-sections (i = 1 to 25) by 252 time series (t = 1982:01 to 2002:12).
In the test stage, the spread-return relation is examined using pooled
cross-section time series GLS regressions, a methodology adopted by Amihud and Mendelson (1986) and Brennan and Subrahmanyam (1996). The
explanatory variables of our analysis include the estimated fundamental
v
a
a
a
l
, the level (Sit1
Smt1
), and the sensitivity (Sit1
it1
betas it1
a
l
Smt1 mt1 ) of amortized spreads. The aforementioned regressors are prescribed by Eq. (14). Two additional regressors are added as control variables
based on the extant literature. Fama and French (1992) argue that rm
size might proxy for loadings on other fundamental risk factors. Elfakhani,
Lockwood and Zaher (1998) nd a signicant size eect for Canadian
stocks. Therefore, the natural logarithm of portfolio i s market capitalization ln(Vit1 ) is included in our tests. Since Chalmers and Kadlec (1998)
nd a strong contemporaneous association between the amortized spread
and return volatility, the volatility of excess returns is included in our
cross-sectional equation. Similar to the estimation procedure of fundamenit1 is estimated from
tal betas, portfolio i s return volatility denoted by
the portfolios excess return time series of the past 60 months. The purpose of including the size and volatility factors is to gauge whether these
well-documented eects subsume any of the level or sensitivity eects of the
amortized spread.11
In Table 2, we report the time-series means of the ve independent
i ), level (Sia )
variables that include beta (iv ), size (ln(Vi )), volatility (
a
l
and sensitivity (Si i ) of amortized spreads across the 5 5 size-spread
sorted portfolios. The results indicate that our sorting procedure produces the desired portfolio characteristics, i.e., sizes (amortized spreads)
are monotonically increasing across each size (amortized spread) quintile.
More importantly, the results demonstrate that there exists a large spread
for both the level and sensitivity of the amortized spreads across the 25
11
We do not include the book-to-market ratio as a control variable for the following
reasons: (1) Chalmers and Kadlec (1998) nd that the book-to-market ratio is highly
insignicant in their tests of the amortized spread; (2) Elfakhani, Lockwood and Zaher
(1998) do not nd a highly signicant book-to-market eect for Canadian stocks in their
whole sample; (3) Kothari, Shanken, and Sloan (1995) document survivorship biases in
the book-to-market ratio; and (4) Matching book-to-market ratios from COMPUSTAT to
CFMRC for Canadian stocks drastically reduces our sample size.
December 22, 2006
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00087.tex
Table 2.
Time series means of the independent variables across the 25 portfolios.
i ), level
This table reports the time-series means of beta (iv ), size (ln(Vi )), volatility (
(Sia ) and sensitivity (Sia il ) of amortized spreads across the 5 5 size-spread sorted portfolios. A stocks amortized spread is estimated as the product of the eective spread and
share volume divided by market capitalization. The 25 portfolios are constructed following
the approach of Fama and French (1992). At December of each year starting from 1977,
eligible stocks are sorted rst into ve size portfolios. Then within each size portfolio,
stocks are sorted into ve sub-portfolios based on the rank of the amortized spreads of
stocks. For each of the twelve months in the following year, each stock is assigned to one
a
, and proporof the 25 portfolios and market capitalizations Vit , amortized spreads Sit
tional change in spread Lit for portfolio i are computed for each month t. Each portfolios
v
l
fundamental beta it
1 , liquidity beta it 1 and standard deviation of excess returns
it 1 are then estimated using 60-month time series regressions. The beta, size, return
volatility, and the level and sensitivity of amortized spreads are the time-series averages
for each portfolio for the sample period from 1982:01 to 2002:12.
Amortized Spread
Size
Low
Small
2
3
4
Big
0.75
0.86
0.76
0.81
0.77
Small
2
3
4
Big
High
Market Beta
0.95
1.01
0.90
1.19
1.06
1.12
0.99
1.03
0.95
0.92
0.99
1.30
1.10
1.16
0.95
1.16
1.16
1.28
1.33
1.16
17.31
18.09
18.77
19.75
21.58
Size (logarithm of market capitalization)

17.30
17.36
18.06
18.07
18.84
18.77
19.71
19.75
21.74
21.54
17.34
18.09
18.80
19.66
21.34
17.31
18.09
18.80
19.68
21.03
Small
2
3
4
Big
0.068
0.058
0.052
0.051
0.049
Volatility (standard deviation of returns)

0.065
0.068
0.072
0.059
0.070
0.076
0.063
0.065
0.065
0.058
0.056
0.066
0.056
0.054
0.058
0.069
0.073
0.066
0.069
0.055
Small
2
3
4
Big
0.048
0.043
0.038
0.029
0.011
0.057
0.063
0.052
0.041
0.021
0.104
0.080
0.067
0.050
0.029
0.170
0.095
0.074
0.062
0.037
0.254
0.108
0.082
0.073
0.044
Small
2
3
4
Big
0.079
0.081
0.036
0.050
0.003
Sensitivity (%)
0.025
0.038
0.035
0.041
0.040
0.089
0.021
0.030
0.010
0.012
0.066
0.089
0.158
0.026
0.018
0.082
0.019
0.202
0.036
0.013
Level (%)
December 22, 2006
15:53
WSPC/155-RPBFMP
00087.tex
portfolios (i.e., the level ranges from 0.011 to 0.254, and the sensitivity ranges from 0.003 to 0.202). This is important, as the cross-sectional
dispersions of the level and sensitivity are necessary to provide explanatory power of expected returns beyond that explained by the other independent variables. The cross-sectional dispersion of the amortized spreads
implies that the liquidity clientele hypothesis may not hold in our sample of Canadian stocks. This is consistent with other studies (Brennan
and Subrahmanyam, 1996; Chalmers and Kadlec, 1998) that do not nd
the clientele eect for US stocks.12 Furthermore, the correlation coecient
between the level and sensitivity eects is moderate ( = 0.32). This suggests that the two eects may play dierent roles in explaining expected
returns.
Prior to testing the cross-sectional relation between expected returns and
amortized spreads, we run pooled GLS regressions without including the
amortized spread as explanatory variables. Doing such allows us to examine
the well-documented relation between returns, betas, sizes, and volatilities
in the Canadian stock markets. Specically, we run the following regression
and report the results in Table 3.
e
v
= 0 + 1 it1
+ 2 ln(Vit1 ) + 3
it1 + it .
Rit
(17)
In Table 3, panels AC report results for the whole test period (1982:01
to 2002:12), rst half-period (1982:01 to 1992:06), and second half-period
(1992:07 to 2002:12), respectively. With regard to the size eect, we conrm
the nding of Elfakhani, Lockwood and Zaher (1998) that rm size is negatively related to stock returns in the Canadian market. The size eect is
signicant and robust for both the whole period and the two sub-periods.
We also nd a positive relation between volatilities and returns. This association is signicant for the rst sub-period (3 = 0.347 and t-value = 2.39),
but becomes insignicant for the second sub-period (3 = 0.127 and
t-value = 0.87). As for the risk-return relation, we nd that betas are negatively but insignicantly related to returns during the rst sub-period. This
nding is consistent with that of Elfakhani, Lockwood and Zaher (1998) for
12
If the liquidity clientele hypothesis holds, then the cross-sectional dispersion of amortized
spreads should be small since high (low) spread portfolios tend to have low (high) turnover
rates. Brennan and Subrahmanyam (1996) do not nd a concave relation between the
xed costs of transacting and investment horizons for NYSE stocks. Chalmers and Kadlec
(1998) nd a positive association between spreads and turnovers, which is in contrast to
the prediction of the clientele eect. These ndings further justify our examination of the
return-spread relations without presuming the clientele hypothesis of liquidity.
December 22, 2006
15:53
WSPC/155-RPBFMP
00087.tex
Table 3.
The cross-sectional relation between returns and betas, sizes, and volatilities.
This table reports the test results for the cross-sectional relations between portfolio returns
and portfolio betas, sizes, and volatilities. Panels AC are the results for the whole
test period (1982:012002:12), rst sub-period (1982:011992:06), and second sub-period
(1992:072002:12), respectively. The test portfolios are constructed following the approach
of Fama and French (1992). At December of each year starting from 1977, eligible stocks
are sorted rst into ve size portfolios. Then within each size portfolio, stocks are sorted
into ve sub-portfolios based on the rank of the amortized spreads of stocks. For each
of the 12 months in the following year, each stock is assigned to one of the 25 portfolios
e
(in excess of the proxy of the zero-beta rate Rzt )
and equal-weighted excess returns Rit
and market capitalizations Vit for portfolio i are then computed for each month t. We
v
then estimate each portfolios fundamental beta it
1 and standard deviation of excess
returns
it1 using 60-month time series regressions. Asset pricing tests are conducted
using the pooled cross-sectional and time series regressions for the whole test period and
two sub-periods. Specically, the coecients (0 , 1 , 2 , 3 ) are estimated from the following model:
e
v
= 0 + 1 it1
+ 2 ln(Vit1 ) + 3
it1 + it
Rit

(i = 1 25; t = 1982:012002:12).
,
and indicates signicance based on a
T -statistics are reported in parentheses.
two-tailed test at the 1%, 5% and 10% levels, respectively.
Run
Intercept (0 )
Beta (1 )
Log of Size (2 x100)
Volatility (3 )
Panel A: Whole test period (t = 1982:012002:12)

(1)
0.013
0.009
(2.56)
(2.15)
(2)
0.020
0.011
(3.42)
(2.73)
(3)
0.018
0.019
(3.69)
(2.56)
0.199
(4.11)
0.156
(3.04)
0.191
(1.82)
Panel B: First sub-period (t = 1982:011992:06)

(1)
0.002
0.002
(0.23)
(0.45)
(2)
0.015
0.006
(1.49)
(1.39)
(2)
0.016
0.009
(1.70)
(1.72)
0.211
(3.86)
0.173
(2.80)
0.347
(2.39)
Panel C: Second sub-period (t = 1992:072002:12)

(1)
0.015
0.015
(3.44)
(2.36)
(2)
0.023
0.015
(3.96)
(3.18)
(3)
0.021
0.020
(2.93)
(3.10)
0.196
(3.16)
0.169
(2.48)
0.127
(0.87)
a somewhat similar time period (i.e., their data is from 1975:07 to 1992:12).
However, we nd that the negative beta-return relation becomes highly signicant for the second sub-period and the whole period, even after size and
volatility are controlled for. The negative beta eect is counterintuitive, but
December 22, 2006
15:53
WSPC/155-RPBFMP
00087.tex
is neither a new nding nor unique to our study. Elfakhani, Lockwood and
Zaher (1998) document negative risk premia for beta (although insignicant) in all test samples of Canadian stocks. Chalmers and Kadlec (1998),
Datar, Naik and Radclie (1998), and Eleswarapu and Reinganum (1993)
report a signicantly negative beta eect for the US stock market for tests
of the return-liquidity relation.
To further investigate the possible causes of this negative beta eect,
we employ the conditional beta approach proposed by Pettengill, Sundaram
and Mathur (1995). The authors argue that when using realized returns to
test the CAPM, beta should be positively related to returns when the excess
market returns are positive, but a negative relation should be expected when
the excess market returns are negative. Therefore, we use conditional betas
in our subsequent analysis. The most comprehensive specication of our
model is given below:
e
+
= 0 + +
Rit
1 it1 + 1 (1 )it1 + 2 ln(Vit1 )
a
a
l
it1 + 0 (Sit1
) + 1 (Sit1
) + it
it1
+ 3
(i = 1 to 25 and t = 1982:01 to 2002:12).
(18)
where
is a dummy variable: = 1 if Rmt Rzt 0 and = 0 if Rmt Rzt < 0,
a
(Sita 1 ) Sita 1 Smt
1 is the cross-sectional mean-adjusted loadings
on the level eect (0 ), and
a
l
(Sita 1 itl 1 ) Sita 1 itl 1 Sim
1 mt 1 is the cross-sectional meanadjusted loadings on the sensitivity eect (1 ).
The primary focus of the test is to examine the magnitude and signi
cance of 0 and 1 after controlling for the conditional betas (+
1 and 1 ),
size (2 ), and volatility (3 ) eects. If investors do command a higher premium to hold stocks with higher levels of the amortized spread, a positive
and signicant 0 is expected. Furthermore, if investors also require incremental compensations for stocks with higher sensitivities to market-wide
liquidity shocks, then 1 should be positive and signicant.
Pooled cross-section time series GLS regressions are used to estimate
Eq. (18). Results for the whole test period are reported in Table 4. The
estimates and signicance of the level eect (0 ) and the sensitivity eect
(1 ) are reported in the last two columns of Table 4.
Results from panels A and B of Table 4 provide preliminary evidence
on the level and sensitivity eects of the amortized spread, when the two
eects are tested separately. Observe from Panel A that when tested alone,
The cross-sectional relation between returns and amortized spreads for the whole test period.
Intercept (0 )
Panel A: Level eect

(1)
0.011
(2.65)
(2)
0.021
(3.31)
(3)
0.016
(2.27)
Run
0.020
(5.13)
0.018
(5.28)
0.006
(1.18)
Beta+ (+
1)
0.029
(7.49)
0.031
(8.63)
0.035
(6.64)
Beta (
1)
0.191
(4.36)
0.047
(2.22)
Log of Size (2 100)
0.347
(3.48)
Volatility (3 )
1.005
(3.09)
0.898
(2.78)
0.895
(2.79)
Level (0 )
Sens. (1 )
a
a
a
) Sit1
Smt1
is the mean-adjusted
where is a dummy variable: = 1 if Rmt Rzt 0 and = 0 if Rmt Rzt < 0; (Sit1
a
l
a
l
a
l
loadings on the level eect (0 ); and (Sit1 it1 ) Sit1 it1 Smt1 mt1 is the mean-adjusted loadings on the sensitivity eect
(1 ). T -statistics are reported in parentheses. , and indicates signicance based on two-tailed tests at the 1%, 5% and 10% levels,
respectively.
(i = 125; t = 1982:012002:12),
15:53
e
a
a
l
+
Rit
= 0 + +
it1 + 0 (Sit1
) + 1 (Sit1
) + it
it1
1 it1 + 1 (1 )it1 + 2 ln(Vit1 ) + 3
This table reports the test results for the level and sensitivity eects for the amortized spread for the test period from 1982:01 to 2002:12.
Panels A and B report the results for the level and sensitivity eects alone, respectively. Panel C reports the results for the joint test of
the level and sensitivity eects. A stocks amortized spread is estimated as the product of the eective spread and share volume divided
by market capitalization. The test portfolios are constructed following the approach of Fama and French (1992). At December of each
year starting from 1977, eligible stocks are sorted rst into 5 size portfolios. Then within each size portfolio, stocks are sorted into 5 subportfolios based on the rank of the amortized spreads of stocks. For each of the 12 months in the following year, each stock is assigned to
e
(in excess of the proxy of the zero-beta rate Rzt ), market capitalizations Vit ,
one of the 25 portfolios and equal-weighted excess returns Rit
a
amortized spreads Sit , and proportional change in spread Lit for portfolio i are computed for each month t. Each portfolios fundamental
v
l
beta it1
, liquidity beta it1
and standard deviation of excess returns
it1 are then estimated using 60-month time series regressions.
Asset pricing tests are conducted using the pooled cross-sectional and time series regressions for the whole test period. Specically, the
coecients (0 , +
1 , 1 , 2 , 3 , 0 , 1 ) are estimated from the following model:
Table 4.
December 22, 2006

WSPC/155-RPBFMP
00087.tex
0.019
(5.07)
0.018
(5.18)
0.006
(1.15)
0.030
(7.64)
0.031
(8.72)
0.035
(6.64)
Beta (
1)
Panel C: Joint eect

(1)
0.011
(2.49)
(2)
0.018
(2.92)
(3)
0.014
(2.09)
Beta+ (+
1)
0.030
(7.53)
0.031
(8.62)
0.035
(6.59)
Intercept (0 )
Panel B: Sensitivity eect

(1)
0.011
0.019
(5.00)
(2.71)
(2)
0.021
0.018
(5.17)
(3.02)
(3)
0.016
0.006
(1.19)
(2.28)
Run
0.178
(4.05)
0.094
(1.98)
0.188
(4.23)
0.105
(2.19)
Log of Size (2 100)
(Continued )
0.340
(3.40)
0.339
(3.38)
Volatility (3 )
0.762
(2.47)
0.689
(2.37)
0.698
(2.41)
Level (0 )
1.806
(2.83)
1.596
(2.55)
1.520
(2.46)
2.176
(3.52)
1.920
(3.15)
1.843
(3.06)
Sens. (1 )
15:53
Table 4.
December 22, 2006

WSPC/155-RPBFMP
00087.tex
December 22, 2006
15:53
WSPC/155-RPBFMP
the level eect of the amortized spread is signicant at the 1% level across all
the tested models. In terms of the estimates, 0 is relatively stable, ranging
from 0.895 to 1.005 within Panel A. Compared to the results of Chalmers and
Kadlec (1998) that weakly support the level eect of the amortized spread
for US stocks (NYSE and AMEX) during 1983 to 1992, our estimates of the
level eect for Canadian stocks exhibit higher signicance.13 From Panel B,
we observe that the estimates of the sensitivity eect are about twice as
large as those for the level eect. Their values range from 1.843 to 2.176,
which suggests that the sensitivity eect play a stronger asset-pricing role
than the level eect. The estimates of the sensitivity eect are stable and
signicant at the 1% level.
In Panel C, we report the test results for the existence of the level and
sensitivity eects of the amortized spread. When jointly estimated in the
same regressions, both 0 and 1 are positive and signicant across dierent
sets of control variables. Specically, 0 ranges from 0.689 to 0.762 (t-values
from 2.37 to 2.47), and 1 ranges from 1.520 to 1.806 (t-values from 2.46
to 2.83). The incremental nature of the sensitivity eect (1 ) is preserved
by the FrischWaugh theorem of multiple linear regressions (Greene, 1997,
a
is controlled for, the
p. 246); in Eq. (18), given that the level eect on Sit1
sensitivity eect (1 ) is solely attributed to the cross-sectional variation in
l
). The joint eect of the level and sensitivity of the
the liquidity beta (it1
amortized spread is not subsumed by the eects of conditional betas, rm
size, and return volatility. However, both the magnitude and signicance of
0 and 1 are smaller than the results in panels A and B where the two
eects are estimated separately, due to the positive correlation between the
loadings on 0 with those on 1 . Finally, we note that all the intercepts (0 )
are signicantly positive in Table 4. However, this is not a rejection of the
cross-sectional model (Fama, 1976).
The results in Panel C support the hypothesis that both level and sensitivity eects of liquidity exist in our whole sample. In turn, this suggests
that investors not only take the level of transaction costs into consideration
when making portfolio decisions but they also require an incremental reward
for assets that are more sensitive to market-wide liquidity shocks. However,
we observe before that the time series behavior of the amortized spread for
the market portfolio experiences dramatic changes from the rst sub-period
to the second sub-period. Specically, we nd both a higher level and higher
13
See Table 7 of Chalmers and Kadlec (1998). The p-values of their estimates of the
amortized spread range from 0.18 to 0.02.
00087.tex
December 22, 2006
15:53
WSPC/155-RPBFMP
00087.tex
volatility of the amortized spread during the second sub-period, which is

characterized by reduced unit trading costs but increased trading activities (see Figs. 1 and 2). This observation motivates us to conduct the same
pooled GLS regressions for each sub-period, and to compare the behaviors
of both eects across the two sub-periods.
The empirical results are reported in Panels A and B of Table 5 for
the rst and second sub-periods, respectively. From Panel A, we nd strong
evidence for the level eect in terms of both magnitude and signicance, but
no evidence for the sensitivity eect. The estimates of the level eect (0 )
range from 3.828 to 5.842 (t-values from 2.27 to 3.04), which is about 8 times
as large as the illiquidity premium when the overall sample is used. On the
other hand, the estimates of the sensitivity eect (1 ) are very weak in both
magnitude (coecients from 0.101 to 0.597) and signicance (t-values from
0.12 to 0.73). The evidence suggests that during the rst sub-period, the level
eect completely dominates the sensitivity eect for the amortized spread.
From Panel B, we nd a highly strong sensitivity eect and a positive
but insignicant level eect for the amortized spread during the second subperiod (1992:07 to 2002:12). The estimates of the sensitivity eect (1 ) range
from 3.600 to 4.446 (t-values from 2.69 to 3.32). These estimates are about
twice as large as those estimates when the overall sample is used. However,
the level eect of trading costs is much weaker. The estimates of the level
eect (0 ) that range from 0.470 to 0.523 have the predicted positive sign,
which implies that investors still require a higher premium for stocks with
higher levels of transaction costs. However, the premium is insignicant at
conventional condence levels (t-values from 1.40 to 1.55).
These sub-period ndings indicate an intertemporal shift in the relative
importance of the level and sensitivity eects of the amortized spread: a
strong level eect gives way to a prominent sensitivity eect across the two
sub-periods we investigate. During the rst sub-period (1982:01 to 1992:06),
investors are highly averse to the level eect. They demand a signicant
premium for any anticipated increase in the level of trading costs. On the
other hand, investors do not seem to care much about systematic liquidity
risk before the early 1990s. However, during the second sub-period (1992:07
to 2002:12) where both a higher level and higher volatility of the marketaverage trading costs are observed, the relative importance of the level and
sensitivity eects experiences a drastic shift. Although investors still demand
a positive premium for a higher level of trading costs, the premium is small
and insignicant. Instead, investors become highly averse to the liquidity
risk induced by systematic adverse liquidity movements. This suggests that
Cross-sectional relations between returns and amortized spreads for two sub-periods.
Intercept (0 )
Beta+ (+
1)
Beta (
1)
Panel A: First sub-period (t = 1982:011992:06)

(1)
0.003
0.025
0.026
(4.45)
(0.42)
(4.47)
(2)
0.006
0.024
0.026
(4.49)
(0.71)
(4.38)
(3)
0.004
0.011
0.028
(0.21)
(1.53)
(4.94)
Run
0.163
(2.77)
0.058
(0.82)
Log of Size (2 100)
0.398
(2.67)
Volatility (3 )
5.842
(3.04)
4.098
(2.42)
3.828
(2.27)
Level (0 )
0.101
(0.12)
0.307
(0.38)
0.597
(0.73)
Sens. (1 )
a
a
where is a dummy variable: = 1 if Rmt Rzt 0 and = 0 if Rmt Rzt < 0; (Sit
1 ) Sit 1 Smt 1 is the mean-adjusted
a
a
a
l
l
l
loadings on the level eect (0 ); and (Sit
1 it 1 ) Sit 1 it 1 Smt 1 mt 1 is the mean-adjusted loadings on the sensitivity
eect (1 ). T -statistics are reported in parentheses. , and indicates signicance based on two-tailed tests at the 1%, 5% and 10%
levels, respectively.
15:53
e
a
l
Rit
= 0 + +
it 1 + 0 (Sit
1 ) + 1 (Sit 1 it 1 ) + it ,
1 it1 + 1 (1 )it 1 + 2 ln(Vit1 ) + 3
This table reports the test results of the level eect and sensitivity eect of the amortized spread for both sub-periods in our sample.
Panels A and B report the results for the rst sub-period (1982:011992:06) and second sub-period (1992:072002:12), respectively. A
stocks amortized spread is estimated as the product of the eective spread and share volume divided by market capitalization. The test
portfolios are constructed following the approach of Fama and French (1992). At December of each year starting from 1977, eligible stocks
are sorted rst into ve size portfolios. Then within each size portfolio, stocks are sorted into ve sub-portfolios based on the rank of
the amortized spreads of stocks. For each of the 12 months in the following year, each stock is assigned to one of the 25 portfolios and
e
a
(in excess of the proxy of the zero-beta rate Rzt ), market capitalizations Vit , amortized spreads Sit
,
equal-weighted excess returns Rit
v
and proportional changes in spread Lit for portfolio i are computed for each month t. Each portfolios fundamental beta it 1 , liquidity
l
beta it
it 1 using 60-month time series regressions are then estimated. Asset pricing tests
1 and standard deviation of excess returns
are conducted using the pooled cross-sectional and time series regressions for the two sub-periods. Specically, the coecients (0 , +
1,
)
are
estimated
from
the
following
model:
2
3
0
1
1
Table 5.
December 22, 2006

WSPC/155-RPBFMP
00087.tex
Intercept (0 )
Beta+ (+
1)
Beta (
1)
Panel B: Second sub-period (t = 1992:072002:12)

(1)
0.011
0.013
0.036
(3.10)
(7.82)
(2.01)
(2)
0.018
0.013
0.036
(3.25)
(8.19)
(2.65)
(3)
0.017
0.004
0.042
(0.63)
(5.89)
(1.96)
Run
0.117
(2.16)
0.066
(1.09)
Log of Size (2 100)
(Continued )
0.344
(2.50)
Volatility (3 )
0.523
(1.55)
0.470
(1.40)
0.504
(1.50)
Level (0 )
4.446
(3.32)
4.003
(3.03)
3.600
(2.69)
Sens. (1 )
15:53
Table 5.
December 22, 2006

WSPC/155-RPBFMP
00087.tex
December 22, 2006
15:53
WSPC/155-RPBFMP
rational investors, when facing both a higher level and higher volatility of
trading costs, seem to be more concerned with an assets co-movement with
the underlying liquidity factor than the level of transaction costs associated
with that asset.14
Shifts in the importance of the level and sensitivity eects of the amortized spread are consistent with the trading behaviors of investors conjectured by Wilcox (1993). Specically, lower share turnovers indicate that
investors have longer holding periods and thus behave more as value-oriented
investors. As value-oriented investors, they exhibit greater patience when
trading since any private information that they hold is likely to be small
and long lasting. As a result, such investors are concerned more with the
level than the sensitivity of the amortized spread when pricing assets. Conversely, when share turnover is heightened, investors have shorter holding
periods and thus behave more as short-term momentum traders. As shortterm traders, they exhibit lower patience when trading since any private
information that they hold is likely to be large and short lasting. As a
result, such investors are concerned more with the sensitivity than the level
of the amortized spread. The reason is that they are concerned more with
the uncertainty of the amortized spread at the time at which they may need
to make a quick transaction.
To account for the well-known seasonality of liquidity as documented by
Eleswarapu and Reinganum (1993), we repeat the above analysis using data
for non-January months. Table 6 shows the results when we only include
months from February to December of each year.15 Panels AC of Table 6
report the results for the whole test period (1982:01 to 2002:12), rst subperiod (1982:01 to 1992:06), and second sub-period (1992:07 to 2002:12),
respectively. We nd that the level and sensitivity eects are both present
in our overall sample, that the level eect dominates the sensitivity eect for
the rst sub-period, and that the sensitivity eect is more prominent during
the second sub-period. Our conclusion about the level and sensitivity eects
of the amortized spread persists after controlling for the beta, size, and
14
To check whether our ndings are robust with respect to dierent ways of forming subsamples, we omit two years of data from the beginning (middle, end) of our overall sample,
and repeat the same analysis for the modied sub-samples. Doing so does not change our
conclusion regarding the intertemporal shift in the relative importance of the level and
sensitivity eects of the amortized spread.
15
To further test the robustness of our results, we also conduct the same analysis by
excluding other months (i.e., June, September, December, etc.) from our sample, and
reach the same conclusion.
00087.tex
The cross-sectional relation between returns and amortized spreads for non-January months.
Intercept (0 )
Beta+ (+
1)
Beta (
1)
0.179
(3.86)
0.089
(1.87)
Log of Size (2 100)
Panel A: Whole test period (t = 1982:012002:12, non-January)

(1)
0.012
0.021
0.029
(5.71)
(7.43)
(2.88)
(2)
0.018
0.020
0.031
(5.74)
(8.58)
(2.81)
(3)
0.015
0.006
0.037
(1.16)
(6.11)
(1.95)
Run
0.380
(3.92)
Volatility (3 )
0.553
(2.39)
0.508
(2.16)
0.516
(2.20)
Level (0 )
1.505
(2.68)
1.341
(2.46)
1.266
(2.37)
Sens. (1 )
a
a
a
) Sit1
Smt1
is the mean-adjusted
where is a dummy variable: = 1 if Rmt Rzt 0 and = 0 if Rmt Rzt < 0; (Sit1
a
l
a
l
a
l
loadings on the level eect (0 ); and (Sit1
) Sit1
Smt1
is the mean-adjusted loadings on the sensitivity eect
it1
it1
mt1
(1 ). T -statistics are reported in parentheses. , and indicates signicance based on two-tailed tests at the 1%, 5% and 10% levels,
respectively.
15:53
e
a
a
l
+
Rit
= 0 + +
it1 + 0 (Sit1
) + 1 (Sit1
) + it ,
it1
1 it1 + 1 (1 )it1 + 2 ln(Vit1 ) + 3
This table reports the joint test results of the level eect and sensitivity eect of amortized spreads for the months excluding January
of each year. Panels AC report the results for the whole test period (1982:012002:12), the rst sub-period (1982:011992:06) and the
second sub-period (1992:072002:12), respectively. A stocks amortized spread is estimated as the product of the eective spread and
share volume divided by market capitalization. The test portfolios are constructed following the approach of Fama and French (1992).
At December of each year starting from 1977, eligible stocks are sorted rst into ve size portfolios. Then within each size portfolio,
stocks are sorted into ve sub-portfolios based on the rank of the amortized spreads of stocks. For each of the 12 months in the following
e
(in excess of the proxy of the zero-beta
year, each stock is assigned to one of the 25 portfolios and equal-weighted excess returns Rit
a
rate Rzt ), market capitalizations Vit , amortized spreads Sit , and proportional changes in spread Lit for portfolio i are computed for each
v
l
month t. Each portfolios fundamental beta it1
, liquidity beta it1
and standard deviation of excess returns
it1 using 60-month
time series regressions are then estimated. Asset pricing tests are conducted using the pooled cross-sectional and time series regressions
for the months excluding January. Specically, the coecients (0 , +

1 , 1 , 2 , 3 , 0 , 1 ) are estimated from the following model:
Table 6.
December 22, 2006

WSPC/155-RPBFMP
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(t = 1992:072002:12, non-January)
0.015
0.034
(3.50)
(7.08)
0.015
0.034
(3.65)
(7.46)
0.004
0.037
(0.56)
(5.11)
0.144
(2.38)
0.083
(1.27)
Log of Size (2 100)
Panel C: Second sub-period

(1)
0.010
(2.39)
(2)
0.017
(2.45)
(3)
0.017
(1.98)
Beta (
1)
0.152
(2.68)
0.037
(0.54)
Beta+ (+
1)
Panel B: First sub-period (t = 1982:011992:06, non-January)

(1)
0.004
0.025
0.028
(5.19)
(0.75)
(4.67)
(2)
0.006
0.024
0.030
(5.87)
(0.79)
(4.58)
(3)
0.001
0.010
0.036
(0.12)
(1.40)
(4.94)
Intercept (0 )
(Continued )
0.303
(2.21)
0.440
(3.08)
Volatility (3 )
0.323
(1.04)
0.291
(0.95)
0.333
(1.09)
5.800
(3.08)
3.957
(2.49)
3.777
(2.27)
Level (0 )
3.299
(2.59)
3.028
(2.42)
2.619
(2.28)
0.049
(0.06)
0.143
(0.18)
0.468
(0.58)
Sens. (1 )
15:53
Run
Table 6.
December 22, 2006

WSPC/155-RPBFMP
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December 22, 2006
15:53
WSPC/155-RPBFMP
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volatility eects, and is not aected by the inclusion or exclusion of the

month of January.
With regard to the role of conditional betas, we nd that the negative
beta eect documented in Table 3 is well explained by the inverse beta-return
relation that is expected when the realized market returns are below the
zero-beta rate (i.e., Rmt Rzt < 0). We observe from Tables 4 to 6 that the
beta during down-markets (i ) is consistently the most signicant variable
among all the explanatory variables. The estimated risk premium during
+
down-markets (
1 ) dominates the risk premium during up-markets (1 ) in
both magnitude and signicance, especially during the second sub-period
and the whole period. The magnitude of the down-market risk premium,
though large, is comparable to that of US stocks reported by Pettengill,
Sundaram and Mathur (1995).16 Our nding of a stronger down-market beta
eect is in contrast to that of Pettengill, Sundaram and Mathur (1995) who
document a symmetric beta-return relation during up- and down-markets.
Such dierent ndings explain why the unconditional beta-return relation
is signicantly negative in our study, whereas the unconditional beta-return
relation is insignicant in Pettengill, Sundaram and Mathur (1995).
Furthermore, we also nd that return volatility plays an important assetpricing role for Canadian stocks. Firstly, unlike the ndings of Scruggs and
Glabadanidis (2003) and Chalmers and Kadlec (1998) that report a counterintuitive negative return-volatility relation for the US stocks, we nd a
highly signicant and positive return-volatility relation for Canadian stocks
for all the periods under investigation. For example, we observe from Panel C
of Table 4 that the volatility coecient (3 ) is 0.340 and its t-value is 3.40.
Secondly, we nd consistently that when volatility is included as an explanatory variable, the otherwise highly signicant up-market risk premium (+
1)
+
becomes insignicant. For example, based on Panel C of Table 4, 1 is 0.018
and the t-value is 5.18 in model (2), and +
1 drops to 0.006 and the t-value
reduces to 1.15 for model (3). However, whether or not volatility is controlled
for does not aect the magnitude or the signicance of the down-market risk
premium (
1 ). In fact, the estimates of (1 ) become even stronger when
volatility is controlled for, i.e., 0.031 in model (2) and 0.035 in model (3)
based on Panel C of Table 4. This suggests that the volatility of stock returns
eectively captures the relative risk eect when the market outperforms the
zero-beta rate, but that the volatility eect does not subsume the relative
16
In Table 2 of Pettengill, Sundaram, and Mathur (1995), the monthly down-market risk
premium is 0.0337 for their total sample (19361990) of CRSP stocks.
December 22, 2006
15:53
WSPC/155-RPBFMP
risk eect when the market underperforms. Finally, we nd that much of

the explanatory power of rm size is attributable to return volatility. This
is evident by examining models (2) and (3) in Tables 4 to 6. In particular,
we nd from Table 5 that the negative size-return relation is insignicant
when return volatility is included in the regressions.
7. Conclusion
We examine the cross-sectional relation between asset returns and amortized
spreads in an overlapping-generations economy with an average investor.
Instead of presuming a positive correlation between investors holding periods and proportional spreads, we aggregate across investor types to form
a market-average holding period from the view of a representative agent.
We then develop the cross-sectional relation of the amortized spread in a
static economy and impose a factor structure on the systematic component
(so-called commonality) of the amortized spread. In equilibrium, an assets
expected return is theoretically related to its required return through four
asset-pricing channels. Unlike the concave return-spread relation as developed in Amihud and Mendelson (1986), the expected return of an asset is linearly related to its amortized spread. The key observation is the co-existence
of both the level eect that views the amortized spread as an asset characteristic (the static channel) and an incremental sensitivity eect that views
the amortized spread as a risk factor (the dynamic channel).
We empirically examine the relative importance of these two eects in
a large cross section of Canadian stocks. We nd empirical evidence that
supports the co-existence hypothesis over our whole sample period. Thus,
our nding accomplishes the following research agenda proposed in Chordia,
Roll and Subrahmanyam (2000, p. 27):
Finally, an important research issue not investigated here is whether
and to what extent liquidity has an important bearing on asset pricing. . . a higher expected return would surely be required for stocks
with higher average trading costs, but there might be an additional
expected return increment demanded of stocks with higher sensitivities to broad liquidity shocks.
Furthermore, we also document an intertemporal shift in the relative
importance of the two eects across the two sub-periods we investigate.
Specically, we nd that a strong level eect in the rst sub-period gives
way to a prominent sensitivity eect in the second sub-period. This suggests
00087.tex
December 22, 2006
15:53
WSPC/155-RPBFMP
00087.tex
that, when facing both a higher level and volatility of transaction costs that
are induced by more active trading, investors seem to be more concerned
with liquidity co-movements than the levels of trading costs. The relative
importance of the two eects over time is consistent with the determinants
of the trading behavior of the average investor predicated on the value and
rate of decay of information held.
Acknowledgments
Financial support from the Ned Goodman Chair in Investment Finance,
IFM2 and SSHRC is gratefully acknowledged. We would
SSQRC CIRPEE,
like to thank an anonymous referee of this journal, participants at the 2004
NFA Conference (St. Johns), the 2004 CIBC Chair Symposium on Capital
Markets at McMaster University (Hamilton) and the 2005 MFS Conference
(Athens) for their many helpful comments.
Appendix
From Eqs. (7) and (8), the optimization problem for the representative
agent is:

)] = E U W Rf +
Max E[U (W
{Wj }
j Rf )
Wj (R

Wj Sja
(A.1)
j and Sa , the representative

Given the joint normality assumption of R
j
agents end-of-period wealth is completely described by the expected wealth
and the variance of wealth given by:

j Rf ]
] = W Rf +
Wj E[R
Wj E[Sja ]
(A.2)
E[W

) = var
var(W

j
j
Wj R

j

+ var
Wj Sja
j ,
Wj cov R
j
Wj R
j
Wj cov Sja ,

j

Wj Sja .
(A.3)
December 22, 2006
15:53
WSPC/155-RPBFMP
00087.tex
The objective function (A.1) can be expressed in certainty equivalent

form as:
Max
{Wj }
], var[W
]).
U (E[W
(A.4)
Given the constraints (A.2) and (A.3), the Lagrangian equation for each
asset j (j = 1, . . ., J) is formed as:

a
Wj Rj
1 (E[Rj Rf ] E[Sj ]) + 22 cov Rj ,

+ cov Sja ,

j
j

Wj Sja
= 0,
(A.5)
] and 2 U/var[W
] are the Lagrange multipliers
where 1 U/E[W
which, by denition, specify the marginal utility for the expected wealth
(1 ) and the variance of wealth (2 ), respectively. The signs of 1 and 2
can be pre-determined from the behavioral assumptions that the agent is
rational and risk averse. Thus, 1 > 0 and 2 < 0.
By dividing each term of Eq. (A.5) by 1 , we dene the agents marginal
rate of substitution between the expected wealth and the variance of wealth
as 1 /2 > 0. Following the notion of Sharpe (1991), we say that
measures the risk tolerance of the representative investor. It means that the
agents willingness to take one more unit of variance must be rewarded by
more units of expected wealth.
Given the above interpretations, Eq. (A.5) becomes:

2
a
a
a
cov Rj ,
Wj Rj + cov Sj ,
Wj S j ,
E[Rj ] = Rf + E[Sj ] +

j
j = 1, . . ., J.
(A.6)

Next, denote Wm
j Wj as the total wealth invested in all the risky
assets, and wj Wj /Wm as the proportional wealth invested in the jth
risky asset. Eq. (A.6) can be written as:
j , R
m ] + cov[Sa , Sa ]),
j ] = Rf + E[Sa ] + 2Wm (cov[R
(A.7)
E[R
j
j
m

a
a
m
where R
j wj Rj and Sm
j wj Sj denote the fundamental return
and the amortized spread of the market portfolio, respectively.
December 22, 2006
15:53
WSPC/155-RPBFMP
00087.tex
Aggregating across all assets (j = 1, . . ., J) and applying the condition

j wj = 1, we obtain from Eq. (A.7):
2Wm
m ] + var[Sa ]).
(var[R
m
Substituting the term 2Wm / from Eqs. (A.8) into (A.7) yields:
m ] = Rf + E[Sa ] +
E[R
m
j ] = Rf + E[Sja ] +
E[R
(A.8)
j , R
m ] + cov[Sa , Sa ]
cov[R
m
j
a
m ] Rf E[Sm
(E[R
]).
a
var[Rm ] + var[Sm ]
(A.9)
Rearranging terms and making substitutions yield Eqs. (9) and (9.1)
through (9.6).
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December 22, 2006

Review of Pacic Basin Financial Markets and Policies