| Summary: | This study replicates the two-factor Liquidity-Augmented CAPM of Liu (2006) on the JSE over the period 1997–2011. To adjust any risk measures for the downward bias consistent with infrequently traded shares, Fowler and Rorke (1983)’s adjusted OLS coefficients are utilised. Liu’s paper defines liquidity according to the relatively unexplored dimension of trading speed. Measured as a combination of the number of zero daily trades and turnover, this liquidity variable captures the ability of investors to move in and out of positions quickly. The two-factor model is tested against the ordinary CAPM as well as the Fama and French three-factor model in its ability to accurately explain the premiums previously documented with pre-sorted size, value, liquidity, and Beta portfolios. The results are supportive of the two-factor model. The study demonstrates that illiquidity is associated with higher levels of excess returns and that this relationship cannot be captured with the CAPM or the Fama and French three-factor models. Not only does the two-factor model accurately capture the cross-section of returns of liquidity sorted shares, it is also able to better explain the value premium than the other two models. There does not appear to be any size premium over the sample period, although the SMB risk factor is still able to explain some variation in the cross-section of returns. This indicates that although size does seem to proxy for some risk, it is not a priced risk. Most notably, shares sorted according to pre-ranking Beta generate the opposite relationship to what is predicted by the CAPM. There is a consistent and monotonically increasing premium from the high Beta portfolio to the low Beta portfolio. This anomaly cannot be explained by any of the three models.
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