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Full Length Article

Liquidity adjusted capital asset pricing model in an emerging market:

Liquidity risk in Borsa Istanbul*
Erdinç Altay a,*, Seda Çalgıcı b
a _
Istanbul University, Faculty of Economics, Department of Business Management, Istanbul €
Universitesi, _
Iktisat Fak€ _ ‚letme B€ol€
ultesi, Is um€
u, 34452, Beyazıt
_
Istanbul, Turkey
b _
ICBC Turkey, Risk Management Department, Maslak mah. Dereboyu/2 cad. No.13, Sarıyer Istanbul, Turkey
Received 2 March 2019; revised 29 May 2019; accepted 13 June 2019
Available online ▪ ▪ ▪

Abstract

This paper investigates the effect of liquidity risk on asset returns in an emerging market, Borsa Istanbul, under the LCAPM framework. The
results suggest that including illiquidity betas to the CAPM model contribute the explanation power of systematic risks on asset returns. We
employed the classical two stage procedure in order to test the significance of three illiquidity betas as well as the market beta on excess returns.
The results about the significance of the assets' liquidity commonality with the market and the covariance between assets' illiquidity and market
returns present the importance of these illiquidity betas as significant risk factors on asset returns. On the other hand, assets' return sensitivity to
the market liquidity has a positive and significant effect on the asset returns, although it is expected to be negative according to the theory.
_
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ND license (http://creativecommons.org/licenses/by-nc-nd/4.0/).

JEL classification: G0; G1; G12; G15

Keywords: Liquidity risk; Illiquidity; CAPM; Liquidity adjusted CAPM; Emerging markets

1. Introduction model is not adequate enough to explain the complete sys-

The aim of the asset pricing theory is to discover the
functional relation between the asset prices and relevant
pricing factors. CAPM of Sharpe (1964), Lintner (1965) and
Mossin (1966) is the most dominant pricing model in the
finance literature with its linear structure presenting only one
relevant risk, market risk which is measured by market beta.
However, critics of the CAPM and several empirical research
show that market beta as an only risk measure in the pricing
*
This manuscript is based on the graduate dissertation written in Istanbul
University, Social Sciences Institute, Money, Capital Markets and Financial
Institutions graduate program. Empirical analysis is performed by employing
an updated sample data.
* Corresponding author.
E-mail addresses: eraltay@istanbul.edu.tr (E. Altay), sedasertcan@gmail.
com (S. Çalgıcı).
_
Peer review under responsibility of Borsa Istanbul Anonim Sirketi.
tematic risk structure. The critics and empirical evidence
against the inability of the traditional CAPM gave rise to look
for new models to present additional systematic risk factors.
Basu (1977, 1983), Banz (1981), Rosenberg, Reid, & Lanstein
(1985), Bhandari (1988), Jegadeesh (1990), Fama & French
(1992), and Hansen & Jagannathan (1997) introduced firm
size, leverage, book-to-market ratio, price-earnings ratio and
prior returns as additional risk factors on cross sectional asset
returns. Among these factors, recent research presents the
evidence of liquidity risk as another risk factor in explaining
asset returns and augmenting pricing models.
The liquidity is a feature of the assets which is related to the
quick trading at low cost and without changing the price
(Chen, 2005:2 and Liu, 2006:631). Liquidity and its effects in
financial markets are attracting greater interest especially after
the global financial crisis of 2008. Liquidity dry-up is an
important problem especially during the financial crisis.

https://doi.org/10.1016/j.bir.2019.06.002
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2214-8450/Copyright © 2019, Borsa Istanbul Anonim Şirketi. Production and hosting by Elsevier B.V. This is an open access article under the CC BY-NC-ND
license (http://creativecommons.org/licenses/by-nc-nd/4.0/).
Please cite this article as: Altay, E., & Çalgıcı, S., Liquidity adjusted capital asset pricing model in an emerging market: Liquidity risk in Borsa Istanbul, Borsa
_
Istanbul Review, https://doi.org/10.1016/j.bir.2019.06.002
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E. Altay, S. Çalgıcı / Borsa Istanbul Review xxx (xxxx) xxx
R€osch and Kaserer (2013) examine the market liquidity dur-
ing financial crisis and their findings support the positive
relation between market risk and liquidity risk showing that
liquidity decreases when markets decline. They also present
that decrease in funding liquidity increase liquidity common-
ality and decrease the liquidity level of the market.
Due to the importance of liquidity in financial markets,
illiquidity premium hypothesis of Amihud & Mendelson
(1986) should be considered in constructing and testing the
pricing models. Amihud & Mendelson (1986) test the effects
of illiquidity on stock returns and found the evidence of pos-
itive relation between high degree of illiquidity and expected
returns. Among the others, Datar, Naik, & Radcliffe (1998),
Brennan & Subrahmanyam (1996), Amihud (2002), Lesmond,
Ogden, & Trzcinka (1999), Pastor & Stambaugh (2003),
Acharya & Pedersen (2005), Lesmond (2005), Liu (2006),
Korajczyk & Sadka (2008), Johnson (2005) Chordia, Huh, &
Subrahmanyam (2009) and Vu, Chai, & Do (2014) also find
the evidence of the significant relation between liquidity and
asset prices. Along with the evidence of the relation between
asset prices and liquidity, standard CAPM model is adjusted or
augmented by liquidity risk factors and a new version of
CAPM is derived. Acharya & Pedersen (2005) constructed a
liquidity-adjusted CAPM in order to analyze the effects of
liquidity risk factor on asset returns and Liu (2006) imple-
mented the liquidity factor in order to construct a liquidity-
augmented two-factor asset pricing model which is found
robust according to standard CAPM and Fama-French three-
factor model. Acharya & Pedersen (2005) model is also
implemented by several other authors like Lee (2011),
Papvassiliou (2013), Li, Sun, & Wang (2014), Butt & Virk
(2015) and Miralles-Quiros, Miralles-Quiros, & Oliveira
(2017). Lee (2011) reported the evidence of the significant
effect of liquidity risk on asset returns in international markets.
The results achieved by Papvassiliou (2013) also provide
support to the validity of liquidity risk on asset returns in
Greece market. Li et al. (2014) analyzed the Japan market and
Butt & Virk (2015) analyzed the Finnish stock market. They
both reported the superiority of LCAPM over CAPM. The
findings of Miralles-Quiros et al. (2017) also support the
significance of liquidity risk on asset returns in Portuguese
stock market especially when it is classified as an emerging
market during the period of January 1988 to November 1997.
Liquidity aspects are especially important in emerging
markets. Calderon-Rossell (1990), and Yartey (2008) consider
the economic growth and stock market liquidity as two main
determinants of stock market development. Emerging markets
present low liquidity and infrequent trading characteristics
relative to developed markets. Zhang (2010) states that in-
vestors are sensitive to liquidity risk especially in emerging
markets. This statement supports the importance of consid-
ering the liquidity risk while testing the CAPM in emerging
markets.
Standard asset pricing theories assume that markets are
frictionless. This implies that asset prices are given, trading do
not affect the asset prices and assets can be traded at no cost.
(Amihud, Mendelson & Pedersen, 2005: 274) Although one
Please cite this article as: Altay, E., & Çalgıcı, S., Liquidity adjusted capital asset pricing model in an emerging market: Liquidity risk in Borsa Istanbul, Borsa
_
Istanbul Review, https://doi.org/10.1016/j.bir.2019.06.002
can say that traditional asset pricing theory does not focus on
frictions arising from the illiquidity and their effects on price
formation process, there are several empirical studies imple-
mented liquidity in pricing mechanism also in emerging
markets. Bekaert & Harvey (2007), found the evidence of
significant effects of illiquidity on asset returns in 18 emerging
markets. Hearn & Piesse (2009) tested the three-factor CAPM
augmented with liquidity factor in 4 African stock markets and
found the evidence of significant effects of illiquidity risk on
asset returns. Hearn (2010) analyzed augmented CAPM by
size and liquidity risk in the Pakistan, Bangladesh and Sri
Lanka stock markets and presented the importance of liquidity
factor except for Sri Lanka. Another research by Minovic &
Zivkovic (2010) also presented the evidence of the signifi-
cant effect of liquidity risk on asset returns in Serbian stock
market. Lischewski & Voronkova (2012) investigated the
significance of liquidity risk on asset returns in a multifactor
pricing model in Polish stock market. They concluded that
liquidity risk was less relevant than market, size book-to-
market factors. Minovic and Zirkovic (2012) analyzed the
effects of liquidity, book to market ratio and size factors in
Serbian stock market. They found the evidence of two factor
model of Liu (2006) which employs liquidity risk, performs
better than standard CAPM and Fama-French three factor
model. The above stated evidence supporting the liquidity risk
as a complementary risk factor in asset pricing motivates to
test liquidity-adjusted CAPM (LCAPM) in other capital
markets. In this paper, we tested LCAPM in another emerging
market, Borsa Istanbul (hereafter BIST), in order to analyze
the effect of liquidity risk on asset returns. While there is a
significant number of research that cannot support the validity
of standard CAPM in BIST, addition of liquidity risk into the
model may improve our understanding of the asset pricing
phenomenon in this emerging market.
The liquidity risk is especially important in emerging
markets as Zhang (2010) stated. The low liquidity and infre-
quent trading characteristics of emerging markets increase
liquidity risk although they attract the investors by their high
return potential. High economic and political risks of
emerging markets make them subject to financial crisis.
Yeyati, Schumukler & Van Horen (2008) analysed the finan-
cial markets of emerging economies during financial turmoils.
They stated that the cost of trading and illiquidity increased
during the financial crises. Bekaert & Harvey (2003) point out
the problem about the standard models that were ill-suited to
deal with the specific circumstances arising in emerging
markets. The aim of this research is to examine the role of
liquidity risk in asset pricing under the framework of LCAPM
in BIST. Analyzing the effect of liquidity on asset prices in
BIST as a rapidly growing market may provide further un-
derstanding about the risk of liquidity in emerging markets.
We implemented a transformed version of Amihud's (2002)
illiquidity measure which was generated by Acharya &
Pedersen (2005) in order to analyze the different aspects of
illiquidity risk on asset returns in BIST and compare the dif-
ferences with the evidence presented by previous research
about the developed markets which present highly liquid and
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stable characteristics. As far as we know this is the first
research about the empirical test of LCAPM in Borsa Istanbul.
The results show that the liquidity is an important risk factor
also in Borsa Istanbul. The evidence about the significance of
liquidity risk is parallel with some other research in developed
and emerging markets.
BIST (previously known as Istanbul Stock Exchange) is an
electronic market which is founded in December 1985 and
commenced its operations in January 1986. The number of
listed stocks in BIST is over 400 and the market capitalization
is 794,823.08 million TL (150,506.17 million USD) as of the
end of 2018 (Fig. 1). The traded volume (Fig. 2) presents a
similar ascending trend. Investors are allowed to trade through
brokerage houses by placing their orders via phone, fax, email
or electronic trading platform. There are two continuous-
auction sessions and one single-price auction for deter-
mining the starting price (Uslu & Evren, 2018: 178).
The paper proceeds as follows. Section 2 describes several
liquidity measures implemented in different asset pricing
models. Section 3 defines LCAPM. Section 4 gives the main
empirical results and interpretations of the tested model.
Section 5 concludes.
2. Liquidity measures
Kyle (1985) defines different aspects of liquidity as tight-
ness, depth and resilience of the market. Tightness is the cost
of quickly buying and selling of the assets, depth is the amount
of buying or selling to change the price and resilience is the
speed of the price to turn back to the fundamental value after a
non-informational trade. While there are different aspects of
liquidity (or illiquidity), there are also different sources of it.
One source of illiquidity is transaction costs that can be seen in
the form of order processing costs, commission costs or
searching costs. Another source of illiquidity is due to asym-
metric information cost or information of some traders about
others' endowments. The third source can be defined as the
imperfect competition arising from the transactions of large
traders. Another source of the illiquidity can be attributed to
Knightian uncertainty which causes traders to widen the bid-
ask spreads to protect themselves from the potential losses
during the completely unanticipated conditions. Ambigious
conditions restrict markets to be traded at the equilibrium
spreads (Pritsker, 2003:128e129).
Due to the different aspects and sources of liquidity (or
illiquidity), there is a wide range of different measures
implemented as liquidity proxies. Acharya & Pedersen (2005),
Brennan & Subrahmanyam (1996) and Amihud (2002) use a
price impact measure. Price impact measure is designed to
capture the effect of one US$ of trading volume on the prices.
According to this measure, the percentage price change per
US$ of daily trading volume as a proxy of illiquidity of an
asset is
1 X Dit
jRi;d;t j
ILLIQi;t ≡ ð1Þ
Di;t d¼1 Vi;d;t
whereas illiquidity of market is
1 X Nt
ILLIQt ≡ ILLIQi;t ð2Þ
Nt j¼1
where ILLIQi;t , is the illiquidity ratio of asset i on month t, Ridt
is the return of asset i on day d in month t, Vi;d;t is the Turkish
Lira trading volume of asset i on day d in month t, Di;t is the
number of days in month t of asset i and Nt is the number of
assets available in month t (Hearn & Piesse, 2009). Pritsker
(2003) states that order flow measures are advantageous
because they are based on the observed price changes asso-
ciated with trades. Marcelo, Quiros, & Oliveira (2015) present
three advantages of this measure. First, it is good for capturing
Kyle's (1985) price impact definition, second, it is relatively
easy to obtain the data that is required to compute this mea-
sure, and third, it can also be calculated for the days when
there is no price change. High ILLIQt values are interpreted as
low liquidity.

1000000
900000
800000
700000
600000
500000
400000
300000
200000
100000
0
1.1986
1.1987
1.1988
1.1989
1.1990
1.1991
1.1992
1.1993
1.1994
1.1995
1.1996
1.1997
1.1998
1.1999
1.2000
1.2001
1.2002
1.2003
1.2004
1.2005
1.2006
1.2007
1.2008
1.2009
1.2010
1.2011
1.2012
1.2013
1.2014
1.2015
1.2016
1.2017
1.2018

Total Market Value (TL Million) Total Market Value (USD Million)

Fig. 1. BIST market capitalization, source: https://www.borsaistanbul.com/en/data/data/consolidated-data.

Please cite this article as: Altay, E., & Çalgıcı, S., Liquidity adjusted capital asset pricing model in an emerging market: Liquidity risk in Borsa Istanbul, Borsa
_
Istanbul Review, https://doi.org/10.1016/j.bir.2019.06.002
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E. Altay, S. Çalgıcı / Borsa Istanbul Review xxx (xxxx) xxx

50,000,000
45,000,000
40,000,000
35,000,000
30,000,000
25,000,000
20,000,000
15,000,000
10,000,000
5,000,000
0
1.1986
12.1986
11.1987
10.1988
9.1989
8.1990
7.1991
6.1992
5.1993
4.1994
3.1995
2.1996
1.1997
12.1997
11.1998
10.1999
9.2000
8.2001
7.2002
6.2003
5.2004
4.2005
3.2006
2.2007
1.2008
12.2008
11.2009
10.2010
9.2011
8.2012
7.2013
6.2014
5.2015
4.2016
3.2017
2.2018
Fig. 2. Total traded volume (‘000) of BIST, source: https://www.borsaistanbul.com/en/data/data/consolidated-data.

The return reversal is another liquidity measure based on is the turnover of day i in prior x months, n is the number of
price impact which is developed by Pastor & Stambaugh days in in prior x months, NoSTi is the number of shares traded
(2003). The return reversal measure is a proxy to reflect the in day i, NoSOi is the number of shares outstanding at the end
order-flow temporary price fluctuations. This measure is of the day i and NoTD is the number of trading days over the
generated from the estimated parameters of the following prior x months. 1=ðTRNxÞ
Deflator is chosen as a number between 0 and 1
21x
regression model which utilizes daily data for each month: and NoTD is used to standardize the number of trading days in
h   i order to make the months comparable to each other although
i;tþ1 ¼ g0 þ g1 Ri;t þ rr$;i sign Ri;t :Vi;t þ ei;t
Rexc ð3Þ
exc
the number of trading days in each month can change between
15 and 23. This liquidity measure focuses on trading speed and
where Rexc present some advantages. It captures the continuity of trading,
i;tþ1 is the excess return of stock i over market return
at day tþ1, Ri;t is the return of i at day t, rr$;i is the expected the delay of executing of an order, trading quantity and cost.
return reversal for a given volume and Vi;t is the trading vol- So it reflects the risk that arises from the possibility of an asset
ume of stock i at day t. The cross sectional monthly average that cannot be sold in the market. (Liu, 2006, 635e636).
return reversal measure (RR$;i ) is produced from the rr$;i Amihud & Mendelson (1986) use another illiquidity proxy
parameter which is estimated from above daily regression based on bid-ask spread in order to measure the cost of trade.
model for each month and for each stock: A wider bid ask spread means a high trading cost which is a
nt is the total dollar value at the end of proxy of decreasing liquidity. So assets with higher trading
   X month t-1 of the stocks included in the cross costs require higher returns for investing. Bid ask spread can
nt 1 Nt
RR$;t ¼ : rr$;i sectional average in month t, ð4Þ be calculated as absolute difference between bid and ask pri-
n1 Nt i¼1
ces as follows
RR$;t is the return reversal measure, nt is the total value at
month t-1of the stocks included in the average in month t, Nt is Sa ¼ ðPA  PB Þ ð8Þ
the number of stocks in month t (Chen, 2005: 6e7).
or alternatively it can be calculated as percentage spread
Lesmond et al. (1999), Lesmond (2005) and Liu (2006) use
standardized number of days with turnover-adjusted zero ðPA  PB Þ
trading volume. This measure is designed to capture the speed Sp ¼ ð9Þ
ðPA þ PB Þ=2
of trade. Liu's (2006) liquidity measure is calculated by the
following equation: where Sa is the absolute spread, Sp is the percentage spread, PA is
  the lowest ask price and PB is the highest bid price for a period.
Liquidity 1=ðTRNxÞ 21x
Measure LMx ¼ NoZDVx þ Deflator :NoTD ð5Þ Bid ask spread is useful in reflecting order-processing cost,
asymmetric information cost, inventory-carrying cost and
Near to 1
5 oligopolistic market structure costs. (Sarr & Lybek, 2002, 9e10)
X
n
Another liquidity measure, stock turnover, is used by Espen
TRNx ¼ DTRNx;i ð6Þ
i¼1
& Norli (2005), and Datar et al. (1998). Stock turnover (eq.
(7)) measures the quantity of trades as a liquidity proxy. It is
NoSTi calculated by dividing the trading volume to the number of
DTRNi ¼ ð7Þ shares outstanding and it can be interpreted as a sign of the
NoSOi
holding period of a representative investor. (Mirza, 2010:
where NoZDVx is the number of zero daily volumes in prior x 139e140) High stock turnover rate can be interpreted as in-
months, TRNx is the turnover over the prior x months, DTRNx;i vestors hold stocks for a shorter period.

Please cite this article as: Altay, E., & Çalgıcı, S., Liquidity adjusted capital asset pricing model in an emerging market: Liquidity risk in Borsa Istanbul, Borsa
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Istanbul Review, https://doi.org/10.1016/j.bir.2019.06.002
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There are several other liquidity measures other than the
above stated ones. Among the others, Bekaert & Harvey
(2007) use the ratio of zero daily returns over a month.
Breen, Hodrick & Korajck (2000) generated a measure based
on a regression between return and turnover. Hui and Heubel
(1984) designed a measure which can be calculated by the
ratio of the largest price change divided by the ratio of volume
to market capitalization. Among the wide range of different
liquidity measures, Amihud's (2002) measure is a widely used
one in empirical analysis of liquidity in stock markets. In order
to overcome the stated disadvantages of this measure, we also
implement a normalized version of Amihud's liquidity mea-
sure which generated by Acharya & Pedersen (2005) in this
research. Among the other researches which implement
different liquidity measures in testing CAPM, the research of
Kim & Lee (2014) is an exception by implementing multiple
liquidity measures and principle component of these measures.
3. Liquidity-adjusted capital asset pricing model
LCAPM is looking for the answer of the question “how an
asset's expected return depends on its relative illiquidity cost,
on the market return and on the relative market illiquidity”.
LCAPM, converts the frictionless market conditions of CAPM
to a structure with illiquidity costs presenting the following
conditional asset pricing model:

Et ðRi;tþ1  Ci;tþ1 Þ ¼ Rrf þ Et RM;tþ1  CM;tþ1  Rrf : multiplied
covt ðRi;tþ1  Ci;tþ1 ; RM;tþ1  CM;tþ1 Þ
= L'intercept
vart ðRM;tþ1  CM;tþ1 Þ a
ð10Þ
where Ri;tþ1 is the gross return of asset i at time tþ1, Ci;tþ1 is
the illiquidity cost of asset i at time tþ1, Rrf is the gross risk-
free rate. The eq. (10) can be rewritten in terms of gross
returns
covt ðRi;tþ1 ; RM;tþ1 Þ
Et ðRi;tþ1 Þ ¼ Rrf þ Et ðCi;tþ1 Þ þ lt
vart ðRM;tþ1  CM;tþ1 Þ
covt ðCi;tþ1 ; CM;tþ1 Þ covt ðRi;tþ1 ; CM;tþ1 Þ
þ lt  lt
vart ðRM;tþ1  CM;tþ1 Þ vart ðRM;tþ1  CM;tþ1 Þ
covt ðCi;tþ1 ; RM;tþ1 Þ
 lt
vart ðRM;tþ1  CM;tþ1 Þ
ð11Þ
where lt ¼ Et ðRM;tþ1  CM;tþ1  Rrf Þ is the risk premium,
expected illiquidity cost, Et ðCi;tþ1 Þ, is the Amihud &
Mendelson (1986) illiquidity measure and there are four
betas of reflecting different systematic risk components of
which is related with market risk ðcovt ðRi;tþ1 ;RM;tþ1 ÞÞ, and the
others are related with liquidity risks. First liquidity risk
component ðcovt ðCi;tþ1 ; CM;tþ1 ÞÞ is the covariance between the
asset's illiquidity and the market's illiquidity. This component
presents the commonality in liquidity with the market. A
positive relation between this commonality and expected
returns is anticipated because investors require higher returns
Please cite this article as: Altay, E., & Çalgıcı, S., Liquidity adjusted capital asset pricing model in an emerging market: Liquidity risk in Borsa Istanbul, Borsa
_
Istanbul Review, https://doi.org/10.1016/j.bir.2019.06.002
_
5
for the assets which become illiquid when market's liquidity
decreases. Second liquidity risk component
ðcovt ðRi;tþ1 ; CM;tþ1 ÞÞ represents the relation between the as-
set's return and market's illiquidity. A negative relation is ex-
pected between this liquidity risk and expected return because
investors are willing to accept lower return on assets which
have high returns when market becomes illiquid. The last
liquidity risk is represented by the covariance between asset's
illiquidity and market's return ðcovt ðCi;tþ1 ; RM;tþ1 ÞÞ. The
ability of quick selling at low cost and without changing the
price becomes more important in down markets. Hence in-
vestors accept lower returns from these assets. As a result, a
negative relation is expected between this liquidity measure
and expected asset returns. (Acharya & Pedersen, 2005:
380e382).
Acharya & Pedersen (2005) derive an unconditional
version of the above model in order to test LCAPM. Assuming
constant conditional covariance, unconditional version is
presented as:

Et Ri;tþ1  Rrf;t ¼ Et ðCi;tþ1 Þ þ lb1;i þ lb2;i  lb3;i  lb4;i
ð12Þ
where
covðRi;t ; ½RM;t  Et1 ðRM;t Þ Þ
b1;i ¼ ð13Þ
varð½RM;t  Et1 ðRM;t Þ  ½CM;t  Et1 ðCM;t ÞÞ
covð½Ci;t  Et1 ðCi;t Þ; ½CM;t  Et1 ðCM;t Þ Þ
b2;i ¼ ð14Þ
varð½RM;t  Et1 ðRM;t Þ  ½CM;t  Et1 ðCM;t Þ Þ
covðRi;t ; ½CM;t  Et1 ðCM;t Þ Þ
b3;i ¼ ð15Þ
varð½RM;t  Et1 ðRM;t Þ  ½CM;t  Et1 ðCM;t Þ Þ
covð½Ci;t  Et1 ðCi;t Þ; ½RM;t  Et1 ðRM;t Þ Þ
b4;i ¼ ð16Þ
varð½RM;t  Et1 ðRM;t Þ  ½CM;t  Et1 ðCM;t Þ Þ

l ¼ Eðlt Þ ¼ E RM;t  CM;t  Rrf;t ð17Þ
b1;i is the market beta, b2;i is the commonality in liquidity
of i with the market, b3;i is the return sensitivity of i to the
market liquidity, b4;i is the liquidity sensitivity of i to the
market returns and l is the risk premium.
4. Empirical test of LCAPM in BIST
We implemented the well-known two stage Fama &
MacBeth (1973) method in order to test LCAPM in BIST.
The sample period of the test is January 1997-Ocober 2018.
4.1. Data and illiquidity measure
Stock data is comprised of all 325 stocks that are traded in
BIST which is obtained from the All Shares Index data of
Thompson Reuters. Closing price and trading volume daily
data of individual stocks and BIST-100 index are obtained
from the same data supplier. Daily data covers the period of

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E. Altay, S. Çalgıcı / Borsa Istanbul Review xxx (xxxx) xxx
2nd January 1996e31st December 2018. Interest rates are
obtained from the statistics of Republic of Turkey Ministry of
Treasury (Average cost of fixed income internal debt:
2003e2018) and Finance and The Central Bank of the Re-
public of Turkey (The average one month deposit interest rate:
1997e2003).
Daily returns which are calculated by the first difference of
logarithmic closing prices and trading volumes of each stock
are used in order to estimate daily illiquidity measures. Daily
illiquidity measure is estimated by using the following
equation:
jRi;d;t j 6
ILLIQi;d;t ¼ 10
Vi;d;t
where, ILLIQi;d;t is the illiquidity measure, Ri;d;t is the return
and Vi;d;t is the trading volume of the stock i in day d of
month t.
Following the measurement of the daily illiquidities of each
individual stock, stocks are grouped into 25 equal weighted
portfolios which are constructed according to their previous
year's average daily illiquidity levels. These portfolios are
revised in each year according to the same criteria: previous
year's illiquidity level. Then the monthly returns and illiquidity
measures of each stock and index are generated. Monthly
returns are the sum of the daily returns in each month.
Monthly illiquidity measure is constructed by averaging the
daily illiquidity measures in each month;
1 X Dit
ILLIQi;t ¼ ILLIQi;d;t
Di;t d¼1
where, ILLIQi;t is the illiquidity measure of stock i and BIST-_
100 index in month t and Di;t is the number of days in month t.
Monthly portfolio returns and illiquidity measures are
calculated by the arithmetic average of the illiquidity measures
of the stocks in the portfolios. Portfolio 1 is the lowest illiquid
(the highest liquid) portfolio and portfolio 25 is the highest
illiquid (the lowest liquid) portfolio. The returns of BIST-100
index is implemented as the proxies of market portfolio
returns.
Acharya & Pedersen (2005) pointed two important prob-
lems arising from this kind of illiquidity formulation. The first
is that it is not stationary, and the second is it does not measure
the cost of trading but it measures the cost of selling. So, the
following normalized measure of illiquidity is implemented in
order to overcome above stated problems:
 sharp decrease in BIST100 at the end of 2008. In the last
Ci;t ¼ min 0:25 þ 0:30 ILLIQi;t PM;t1 ; 30 ð20Þ
where Ci;t is the normalized illiquidity measure and PM;t1 is
the ratio of closing level of BIST-100 index at month t-1 to the
closing level of BIST-100 index at the end of the first month of
the period.1
1
See Acharya & Pedersen, 2005, pp. 386e387 for the details of normali-
zation process.
Please cite this article as: Altay, E., & Çalgıcı, S., Liquidity adjusted capital asset pricing model in an emerging market: Liquidity risk in Borsa Istanbul, Borsa
_
Istanbul Review, https://doi.org/10.1016/j.bir.2019.06.002
+ MODEL
4.2. Illiquidity and illiquidity innovations in BIST
In the first step of the Fama & MacBeth (1973) method,
monthly beta coefficients are estimated for each portfolio for
the period of January 1997eOctober 2018. Eqs. (13)e(16)
require expected market returns and market illiquidity in-
novations in order to estimate the betas. We implemented the
AR(1) specifications for expected portfolio illiquidities. In-
novations in market illiquidity ðCM;t  Et1 ðCM;t ÞÞ and port-
folio illiquidities ðCi;t  Et1 ðCi;t ÞÞ are generated by
subtracting the expected level of illiquidity from the current
illiquidity measures for each month:
ð18Þ Ci;t ¼ w þ 4Ci;t1 þ εt
ð21Þ
EðCi Þ ¼ w þ 4Ci;t1 and Ui;t ¼ εt
where EðCi;t Þ is the expected illiquidity of portfolio i in month
t and Ui;t is the innovations in illiquidity of portfolio i in
month t which is the residual in eq. (21). The same AR(1)
procedure is also implemented in generating innovations in
market portfolio illiquidity.
UM;t ¼ CM;t  EðCM Þ ð22Þ
where, Ui;M is the innovations in illiquidity of market portfolio
in month t. Market illiquidity and BIST-100 index values are
presented in Fig. 3.
On the other hand, AR(1) specification is found insignifi-
cant to produce innovations in portfolio returns. So, expected
monthly portfolio returns ðEðRi;t ÞÞ are generated by utilizing
the optimum ARIMA models with lowest AKAIKE informa-
ð19Þ
tion criteria for each portfolio. Then the differences between
Ri;t and EðRi;t Þ as the innovations in portfolio retuns are
employed in estimating the beta coefficients. This procedure is
also used for generating innovations in market portfolio
returns.
Ut ðRi;t Þ ¼ Ri;t  EðRi Þ ð23Þ
Ut ðRM;t Þ ¼ RM;t  EðRM Þ ð24Þ
Market illiquidity presents three different stages in the
sample period. First period starts from the beginning of the
sample period to the mid-2003. In this period, illiquidity of the
market reaches to its highest levels although it has a
decreasing trend and presents a very volatile structure. In this
period BIST-100 index level is slightly increasing. The second
period ends nearly in mid-2009. In this period volatility of
illiquidity increases and reaches a high level parallel with the
period, BIST100 index increase with a very high volatility
where illiquidity is slightly decreasing with a low volatility.
Table 1 shows the Augmented Dickey Fuller unit root test
results of both illiquidities and illiquidity innovations of
portfolios. All portfolio illiquidity innovations are stationary.
When we look at the illiquidities they are also stationary at
least with intercept, with intercept and trend or with no
intercept and trend.
 + MODEL
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E. Altay, S. Çalgıcı / Borsa Istanbul Review xxx (xxxx) xxx 7

Fig. 3. Market illiquidity (CM;t ) and BIST-100 Index.

The correlation coefficients ðrC;U Þ between illiquidity and Table 1 range between 0.3969 and 0.8106 with the average of
innovations in illiquidity of all portfolios that are presented in 0.6555 and standard deviation of 0.1058.

Table 1
Correlations and stationarity of illiquidity and illiquidity innovations. The table reports Augmented Dickey Fuller test statistics and correlations between portfolio
illiquidities ðCi;t Þ and illiquidity innovations ðUi;t Þ. Portfolio illiquidity refers to normalized version of Amihud's (2002) illiquidity measure: Ci;t ¼
1 XDit
minð0:25 þ 0:30 ILLIQi;t PM;t1 ; 30Þ where ILLIQi;t ¼ d¼1
ILLIQi;d;t . Illiquidity innovations is the residual of the following AR(1) procedure: Ci;t ¼ w þ
Di;t
4Ci;t1 þ εt .
i rC;U a Augmented Dickey Fuller Testb
Ci;t Ui;t
intercept trend and intercept none intercept trend and intercept none
t-stat prob. t-stat prob. t-stat prob. t-stat prob. t-stat prob. t-stat prob.
P1 0.5427 3.5569 0.0073 2.9015 0.1639 1.7393 0.0778 4.6464 0.0001 4.7710 0.0007 4.4349 0.0000
P2 0.5415 4.8368 0.0001 5.0406 0.0002 1.0003 0.2842 17.3626 0.0000 17.4294 0.0000 17.3956 0.0000
P3 0.6801 6.3329 0.0000 6.8126 0.0000 1.0315 0.2719 16.9933 0.0000 17.2931 0.0000 17.0259 0.0000
P4 0.5951 6.2161 0.0000 7.0630 0.0000 1.9388 0.0504 15.2711 0.0000 10.2191 0.0000 15.3000 0.0000
P5 0.5413 4.7609 0.0001 4.8952 0.0004 3.0710 0.0022 17.0320 0.0000 17.0918 0.0000 17.0647 0.0000
P6 0.8076 6.1615 0.0000 6.4869 0.0000 2.6127 0.0090 7.3863 0.0000 7.6258 0.0000 7.4009 0.0000
P7 0.7833 7.8152 0.0000 8.8219 0.0000 1.4543 0.1361 16.8254 0.0000 17.5885 0.0000 16.8577 0.0000
P8 0.7349 5.0406 0.0000 5.5236 0.0000 3.4072 0.0007 7.3079 0.0000 19.5613 0.0000 7.3222 0.0000
P9 0.6493 2.4482 0.1297 2.8618 0.1769 1.7974 0.0688 5.0562 0.0000 5.2514 0.0000 5.0367 0.0000
P10 0.8106 8.2664 0.0000 8.4722 0.0000 1.2003 0.2104 16.5995 0.0000 16.7564 0.0000 16.6314 0.0000
P11 0.8043 5.0078 0.0000 8.9391 0.0000 2.9272 0.0035 8.1979 0.0000 17.5253 0.0000 8.2136 0.0000
P12 0.7344 7.0747 0.0000 7.7626 0.0000 5.2200 0.0000 16.4841 0.0000 16.9598 0.0000 16.5157 0.0000
P13 0.6202 5.6219 0.0000 6.3239 0.0000 4.1788 0.0000 16.3074 0.0000 16.6796 0.0000 16.3387 0.0000
P14 0.7599 7.4433 0.0000 8.3067 0.0000 1.4106 0.1473 17.0092 0.0000 17.6619 0.0000 17.0418 0.0000
P15 0.7516 5.7182 0.0000 8.0066 0.0000 1.6042 0.1023 17.7618 0.0000 18.3237 0.0000 17.7959 0.0000
P16 0.6977 6.5750 0.0000 7.2230 0.0000 4.4634 0.0000 15.7784 0.0000 16.1542 0.0000 15.8087 0.0000
P17 0.6188 5.5970 0.0000 6.2588 0.0000 4.1062 0.0001 16.7808 0.0000 17.1360 0.0000 16.8131 0.0000
P18 0.7298 7.0156 0.0000 7.4843 0.0000 2.5570 0.0105 17.4560 0.0000 17.8177 0.0000 17.4895 0.0000
P19 0.6546 6.0469 0.0000 6.9522 0.0000 1.6613 0.0913 17.4765 0.0000 18.0713 0.0000 17.5100 0.0000
P20 0.6304 5.7521 0.0000 6.2836 0.0000 2.7045 0.0069 16.1800 0.0000 16.4606 0.0000 16.2111 0.0000
P21 0.6273 5.7270 0.0000 6.0861 0.0000 3.5820 0.0004 17.2391 0.0000 17.4595 0.0000 17.2723 0.0000
P22 0.5784 4.3112 0.0005 5.8809 0.0000 2.8114 0.0050 17.9051 0.0000 18.3481 0.0000 17.9395 0.0000
P23 0.5362 4.7078 0.0001 5.3435 0.0001 2.0001 0.0438 17.9936 0.0000 18.3441 0.0000 18.0282 0.0000
P24 0.5606 2.4646 0.1254 5.3013 0.0001 1.1946 0.2124 17.7250 0.0000 17.9062 0.0000 17.7590 0.0000
P25 0.3969 2.8206 0.0567 2.9602 0.1456 1.1413 0.2309 18.5119 0.0000 18.5666 0.0000 118.5473 0.0000
Aver. 0.6555
Std.dev. 0.1058
a
rC;U is the correlation coefficient between illiquidity and illiquidity innovation of portfolio i.
b
Null hypothesis is Xi;t has a unit root.

Please cite this article as: Altay, E., & Çalgıcı, S., Liquidity adjusted capital asset pricing model in an emerging market: Liquidity risk in Borsa Istanbul, Borsa
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4.3. Illiquidity betas
The first step of the Fama & MacBeth (1973) procedure
requires the estimation of illiquidity and beta coefficients. Eqs.
(13)e(16) are utilized in order to estimate market beta ðb1;i Þ
and illiquidity betas ðb2;i ; b3;i ; and b4;i Þ of 25 liquidity
sorted portfolios. Portfolio betas, excess returns and several
related statistics are presented in Table 2.
In Table 2, the signs of the beta coefficients are parallel to
the theoretical expectations. The market betas ðb1;i Þ of all
portfolios are positive and the b2;i coefficients are positive for
all portfolios. The other illiquidity betas; b3;i and b4;i co-
efficients are negative as they are expected. But when the
correlation matrix presented in Table 3 is examined we get
some controversial results. First of all, high illiquidity port-
folios are expected to have high risk which is measured by
standard deviation of portfolio returns. But the correlation
between average portfolio illiquidity EðCi;t Þ and sðRi;t Þ is
0.7295. The order of portfolios are determined by their
previous year's liquidity level, so the rank correlation between
the order of the portfolio and sðRi;t Þ can show the relation
between previous illiquidity and present risk, which is also
negative (0.8215). On the other hand we find the evidence of
the positive correlation between the portfolio illiquidity and
market capitalization ðEðRi;t  Rrf;t ÞÞ.
Another evidence is about the persistence of the illiquidity.
In general, present average illiquidity of portfolios ðEðCi;t ÞÞ
increase with the order of the portfolios which is constructed
according to the past illiquidities. The correlation between the
order of the portfolios (past illiquidities) and present illi-
quidities ðEðCi;t ÞÞ is 0.9962. Thus, it can be said that illi-
quidity structure is persistent for a long time. It is also seen
that the correlation between illiquidity EðCi;t Þ and standard
deviation of illiquidity innovation sðUi;t Þ is 0.8674, indicating
that highly illiquid portfolios also have high illiquidity inno-
vation variation.
When we examine the market beta, we can see that it de-
creases with the order of portfolios. The correlation between b1;i
and EðCi;t Þ is 0.8357 at %1 significance level. On the other
hand, we see a general tendency of increase in b2;i and decrease
in b4;i with the increase in illiquidies (0.6870 and 0.8442
respectively). Table 3 shows that the absolute values of corre-
lations among beta coefficients are changing between %61 to %
96 which are high. The correlation coefficients among illiquidity
betas are important due to the multicollinearity problem that
arise when they are employed together in a model in order to
analyze the effects of different betas on asset returns. Thus, in
this paper, we constructed different models which employ
different combinations of beta coefficients in order to get a
clearer picture of the illiquidity risk and excess return relation at
the second stage of the analysis.
4.4. Cross sectional regression
The second stage of the Fama & MacBeth (1973) method is
the estimation of the significance of beta parameters on

Table 2
Portfolio beta coefficients (01.1997e12.2018). The table reports market and illiquidity betas, average illiquidities, excess returns, total risks and standard deviation
of illiquidity innovations of liquidity sorted portfolios. b1;i is the market beta, b2;i is the commonality in liquidity of i with the market, b3;i is the return sensitivity of
i to the market liquidity, b4;i is the liquidity sensitivity of i to the market returns, EðCi;t Þ is the average portfolio illiquidity, EðRi;t  Rrf ;t Þ is the excess return of
portfolio i, sðRi;t Þ is the total risk of portfolio i and sðUi;t Þ is the standard deviation of illiquidity innovation.
i b1;i b2;i b3;i b4;i EðCi;t Þ EðRi;t  Rrf ;t Þ sðRi;t Þ sðUi;t Þ
P1 0.3197 0.0167 0.1829 0.0062 0.2644 0.0064 0.1361 0.0093
P2 0.2747 0.0434 0.1701 0.0313 0.3019 0.0081 0.1204 0.0315
P3 0.3060 0.0930 0.1914 0.0539 0.3603 0.0078 0.1340 0.0828
P4 0.2897 0.2732 0.2044 0.1989 0.4433 0.0148 0.1302 0.1655
P5 0.2920 0.3616 0.2047 0.3253 0.8376 0.0094 0.1337 0.4020
P6 0.2808 0.6361 0.1901 0.4775 0.7308 0.0117 0.1284 0.4391
P7 0.2696 0.7352 0.1913 0.4639 0.7170 0.0091 0.1265 0.4277
P8 0.2635 1.0021 0.1745 0.8067 0.9311 0.0106 0.1232 0.7122
P9 0.2626 1.5564 0.1896 0.8460 1.1773 0.0125 0.1266 0.9000
P10 0.2763 1.1433 0.1945 0.9229 1.2492 0.0133 0.1296 0.9165
P11 0.2577 1.2086 0.1906 1.0742 1.2264 0.0067 0.1268 0.8903
P12 0.2510 1.8270 0.1752 1.2319 1.5994 0.0113 0.1238 1.4037
P13 0.2436 2.0494 0.1614 1.2326 1.8989 0.0081 0.1199 1.3879
P14 0.2443 2.4440 0.1983 1.5615 1.9242 0.0093 0.1241 1.4114
P15 0.2359 2.8880 0.1780 2.0045 2.3108 0.0082 0.1163 1.7278
P16 0.2349 3.2766 0.1737 2.2746 2.6511 0.0037 0.1202 1.8499
P17 0.2486 3.3401 0.1926 2.2749 2.9749 0.0108 0.1262 2.0967
P18 0.2289 3.0063 0.1871 2.1270 3.1799 0.0059 0.1179 1.7808
P19 0.2061 4.1026 0.1632 2.8867 3.9317 0.0063 0.1107 2.4129
P20 0.2285 4.6783 0.1622 3.0720 4.4640 0.0009 0.1187 2.5280
P21 0.2167 3.7968 0.1541 2.7681 4.9564 0.0052 0.1222 2.7183
P22 0.2070 5.7028 0.1469 3.6246 6.0998 0.0013 0.1117 3.3252
P23 0.2198 5.2080 0.1725 4.0707 7.9318 0.0064 0.1195 3.4053
P24 0.2019 4.6437 0.1337 3.9487 9.1378 0.0020 0.1131 3.5625
P25 0.1721 3.1549 0.1174 3.6780 15.3723 0.0035 0.1086 3.5383

Please cite this article as: Altay, E., & Çalgıcı, S., Liquidity adjusted capital asset pricing model in an emerging market: Liquidity risk in Borsa Istanbul, Borsa
_
Istanbul Review, https://doi.org/10.1016/j.bir.2019.06.002
 + MODEL
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E. Altay, S. Çalgıcı / Borsa Istanbul Review xxx (xxxx) xxx 9

Table 3
Pearson and Spearman Rank Correlation Matrixes of Portfolio Statisticsa. The table reports the correlation cefficients among market betas, illiquidity betas and
illiquidity orders of portfolios. b1;i is the market beta, b2;i is the commonality in liquidity of i with the market, b3;i is the return sensitivity of i to the market
liquidity, b4;i is the liquidity sensitivity of i to the market returns, EðCi;t Þ is the average portfolio illiquidity, EðRi;t  Rrf;t Þ is the excess return of portfolio i, sðRi;t Þ is
the total risk of portfolio i and sðUi;t Þ is the standard deviation of illiquidity innovation. The lower left part of the matrix presents Pearson correlation coefficients
and the upper right part of the matrix presents the Spearman rank-order correlation coefficients.
r order of i b1;i b2;i b3;i b4;i EðCi;t Þ EðRi;t  Rrf;t Þ sðRi;t Þ sðUi;t Þ
order of i 1 0.9623 0.9577 0.6408 0.9915 0.9962 0.6569 0.8215 0.9931
(0.0000) (0.0000) (0.0006) (0.0000) (0.0000) (0.0004) (0.0000) (0.0000)
b1;i 0.9507 1 0.9215 0.7523 0.9477 0.9508 0.7108 0.9177 0.9477
(0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0001) (0.0000) (0.0000)
b2;i 0.9432 0.8627 1 0.5962 0.9746 0.9538 0.6208 0.7831 0.9638
(0.0000) (0.0000) (0.0017) (0.0000) (0.0000) (0.0009) (0.0000) (0.0000)
b3;i 0.6959 0.7807 0.6158 1 0.6254 0.6285 0.7438 0.7977 0.6338
(0.0001) (0.0000) (0.0010) (0.0008) (0.0008) (0.0000) (0.0000) (0.0007)
b4;i 0.9780 0.9189 0.9635 0.7206 1 0.9892 0.6369 0.8092 0.9923
(0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0006) (0.0000) (0.0000)
EðCi;t Þ 0.8234 0.8357 0.6870 0.8278 0.8442 1 0.6438 0.8108 0.9931
(0.0000) (0.0000) (0.0001) (0.0000) (0.0000) (0.0005) (0.0000) (0.0000)
EðRi;t  Rrf;t Þ 0.6527 0.6210 0.7006 0.7325 0.7132 0.6175 1 0.6654 0.6208
(0.0004) (0.0009) (0.0001) (0.0000) (0.0001) (0.0010) (0.0003) (0.0009)
sðRi;t Þ 0.8118 0.9292 0.7673 0.8003 0.8067 0.7295 0.6212 1 0.8015
(0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0009) (0.0000)
sðUi;t Þ 0.9821 0.9306 0.9483 0.7571 0.9922 0.8674 0.6942 0.8065 1
(0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0001) (0.0000)
a
Pearson correlation coefficients are presented in the lower left part of the table, Spearman rank order correlation is presented in the upper right part of the table,
EðCi;t Þ is the average illiquidity of portfolio i, p-values are stated in parenthesis.

expected portfolio excess returns by implementing a cross
sectional regression. We estimated the parameters of illi-
quidity betas by implementing ordinary least squares regres-
sion method. In order to see the contribution of illiquidity
betas on explaining the excess portfolio returns, we estimated
different combinations of model specifications with market
beta and four illiquidity betas. Estimated models are the ver-
sions of the following basic model with no restrictions on k
and the risk premiums:
 additional risk factors may augment the model.
E Ri;t  Rrf;t ¼a þ kEt ðCi;t Þþ l1 b1;i þ l2 b2;i þ l3 b3;i þ l4 b4;i þ εi
ð25Þ
The findings of different model specifications are presented
in Table 4. The results of Model 1 show that, the market beta
ðb1;i Þ and the assets' return sensitivity to the market liquidity
ðb3;i Þ have positive and statistically significant effects on asset
returns. This result seems to be contradictory to the theory due
to insignificance of b2;i and b4;i as well as the presence of the
positive effect of b3;i although a negative effect is expected for
this risk factor. This result may arise due to the high correla-
tions among exogenous variables in this model (see Table 3).
Thus, we exclude one or more betas from the model and try to
see the general situation by constructing different model
specifications.
The evidence show that expected illiquidity ðEt ðCi;t ÞÞ does
not have a significant effect on excess portfolio returns in all
models when it is employed with the beta coefficients. This
result may also arise from the multicollinearity problem due to
the high correlation among expected illiquidity and beta co-
efficients. In order to see its possible effect on asset returns we
specified Model 12 which employs Et ðCi;t Þ as the only
exogeneous variable. The result suggest that expected illi-
quidity has a positive and significant effect on asset returns.
This evidence is compatible with the findings of Amihud
(2002). Another result derived from the models is about the
effect of market risk premium. The effect of market risk
premiums on asset returns are significant in only three models
out of seven models, so we cannot conclude a strong effect of
market beta on excess returns. This evidence can be inter-
preted as the standard CAPM does not hold in BIST and
We also have some evidence about the significant and
positive effects of commonality in liquidity of portfolios with
the market liquidity ðb2;i Þ on asset returns. But here also we
can see the effect of multicollinearity. Especially in the models
where b2;i is employed with b4;i , the significance of both
variables disappear. Thus, in this stage, we can not see a strong
evidence about the effects of commonality in liquidity of
portfolios with the market liquidity ðb2;i Þ and the liquidity
sensitivity to market returns ðb4;i Þ on asset returns in BIST. On
the other hand, the risk premiums arising from the assets' re-
turn sensitivity to the market liquidity ðb3;i Þ is statistically
significant but positive, opposed to the theory, in all models
presented in Table 4. This positive effect is compatible with
the findings of Minovic & Zivkovic (2010) who analyzed
Serbian market. The positive risk premium means that, in-
vestors are willing to pay premium for assets which have high
returns in times of market illiquidity.
We analyzed four more models due to the multicollinearity
problems arising from the correlations among the exogenous
variables. We regressed all market and illiquidity betas indi-
vidually and also together with expected illiquidity in models

Please cite this article as: Altay, E., & Çalgıcı, S., Liquidity adjusted capital asset pricing model in an emerging market: Liquidity risk in Borsa Istanbul, Borsa
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Table 4
Cross sectional regression results of market and illiquidity betas. The table reports estimated parameters, test statistics, probability values and coefficient of
determinations of the OLS regression models. b1;i is the market beta, b2;i is the commonality in liquidity of i with the market, b3;i is the return sensitivity of i to the
market liquidity, b4;i is the liquidity sensitivity of i to the market returns and EðCi;t Þ is the average portfolio illiquidity.
Model a Et ðCi;t Þ b1;i b2;i b3;i b4;i F test R2 Adj R2
1 Coeff. 0.0048 0.0002 0.0833 0.0013 0.1589 0.0013 9.2277 0.7083 0.6316
p-value (0.7161) (0.7640) (0.0677) (0.6051) (0.0043) (0.7764)
2 Coeff. 0.0048 0.0000 0.0809 0.0020 0.1549 12.0672 0.7070 0.6484
p-value (0.7053) (0.9144) (0.0637) (0.0033) (0.0030)
3 Coeff. 0.0228 0.0005 0.0395 0.0017 8.2397 0.5407 0.4751
p-value (0.1171) (0.1503) (0.4209) (0.0274)
4 Coeff. 0.0219 0.0009 0.0367 0.0033 0.0029 6.0466 0.5474 0.4568
p-value (0.1404) (0.2625) (0.4647) (0.2788) (0.5924)
5 Coeff. 0.0210 0.0001 0.0190 0.1333 8.3352 0.5435 0.4783
p-value (0.0964) (0.8558) (0.5892) (0.0255)
6 Coeff. 0.0206 0.0001 0.0323 0.0028 7.5630 0.5193 0.4507
p-value (0.1637) (0.7171) (0.5193) (0.0474)
7 Coeff. 0.0036 0.0005 0.0835 0.1652 0.0036 11.8958 0.7041 0.6449
p-value (0.7755) (0.1423) (0.0618) (0.0021) (0.0036)
8 Coeff. 0.0132 0.0002 0.0014 0.1271 0.0004 9.3138 0.6507 0.5808
p-value (0.1826) (0.7618) (0.6165) (0.0180) (0.9396)
9 Coeff. 0.0133 0.0003 0.0012 0.1280 13.0334 0.6506 0.6007
p-value (0.1560) (0.3743) (0.0163) (0.0124)
10 Coeff. 0.0113 0.0008 0.0031 0.0033 8.0472 0.5348 0.4683
p-value (0.0000) (0.3137) (0.2973) (0.5338)
11 Coeff. 0.0144 0.0006 0.1335 0.0020 12.7832 0.6462 0.5956
p-value (0.1270) (0.1475) (0.0096) (0.0188)
12 Coeff. 0.0097 0.0008 14.1717 0.3813 0.3543
p-value (0.0000) (0.0010)

13e20 and the findings are presented in Table 5. The summary
results of all models that employ Et ðCi;t Þ together with only
one beta coefficient support the evidence of the significant
effect of illiquidity betas on asset returns but not the market
beta. According to the results, market beta is insignificant but
all illiquidity betas are significant at %5 level. Due to the
correlation between Et ðCi;t Þ and beta coefficients, we further
estimated the models 17e20 and the results supported the
previous findings. But here the market beta has a significant
but negative effect on asset returns. This is another evidence
about the inadequacy of standard CAPM in this emerging
market. We can see that, commonality in portfolio liquidity
with the market ðb2;i Þ is a highly significant risk factor in
BIST. An increase in liquidity commonality of the asset with
the market also increase the asset returns as expected by the
theory, indicating that investors want to be compensated for
investing in assets which become illiquid as the market be-
comes also illiquid. b4;i , the liquidity sensitivity to market
returns is also another significant risk factor on asset returns.
There is a negative relation between b4;i and asset returns as it

Table 5
Cross sectional regression results of market and illiquidity betas individually. The table reports estimated parameters, test statistics, probability values and co-
efficient of determinations of the OLS regression models. b1;i is the market beta, b2;i is the commonality in liquidity of i with the market, b3;i is the return
sensitivity of i to the market liquidity, b4;i is the liquidity sensitivity of i to the market returns and EðCi;t Þ is the average portfolio illiquidity.
Model a Et ðCi:t Þ b1:i b2:i b3:i b4:i F test R2 Adj R2
13 Coeff. 0.0021 0.0004 0.0429 7.8942 0.4178 0.3649
p-value (0.8398) (0.2824) (0.2524)
14 Coeff. 0.0114 0.0003 0.0013 12.2035 0.5259 0.4828
p-value (0.0000) (0.2152) (0.0167)
15 Coeff. 0.0175 0.0000 0.1421 12.7580 0.5370 0.4949
p-value (0.0957) (0.8932) (0.0125)
16 Coeff. 0.0113 0.0001 0.0022 11.4260 0.5095 0.4649
p-value (0.0000) (0.8498) (0.0254)
17 Coeff. 0.0021 0.0766 7.8942 0.4178 0.3649
p-value (0.8398) (0.0009)
18 Coeff. 0.0114 0.0017 12.2035 0.5259 0.4828
p-value (0.0000) (0.0001)
19 Coeff. 0.0175 0.1480 12.7580 0.5370 0.4949
p-value (0.0957) (0.0000)
20 Coeff. 0.0113 0.0023 11.4260 0.5095 0.4649
p-value (0.0000) (0.0001)

Please cite this article as: Altay, E., & Çalgıcı, S., Liquidity adjusted capital asset pricing model in an emerging market: Liquidity risk in Borsa Istanbul, Borsa
_
Istanbul Review, https://doi.org/10.1016/j.bir.2019.06.002
 + MODEL
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E. Altay, S. Çalgıcı / Borsa Istanbul Review xxx (xxxx) xxx 11

is expected by the theory. So, one can conclude that investors
are willing to accept lower returns from the assets that become
liquid in bear markets. This result is also compatible with the
results of another emerging market, Serbian stock market.
Minovic & Zivkovic (2010) state that b4 dominates other risk
factors. The return sensitivity of assets to the market liquidity
ðb3;i Þ is significantly effecting asset returns in BIST, the di-
rection of the effect is positive opposite to the theory. This
means that investors in BIST are willing to accept a higher
returns on assets with high returns in illiquid markets.
Following the possibility of linear combination of betas,
total liquidity risk can be represented as net illiquidity beta
ðbL:i Þ
biL:i ¼ b2:i  b3:i  b4:i
and total systematic risk ðbS:i Þ is the sum of net illiquidity beta
and market beta
bS:i ¼ b1:i þ biL:i
We estimated the following two regression models (eq. (28)
and eq. (29)) in order to analyze the effect of total liquidity
risk (eq. (26)) and total systematic risk (eq. (27)) on asset
returns. The results are presented in Table 6.
 E3 ¼  0:0008 b3;p25  b3;p1 12 ¼ 0:065%
Et Ri:t  Rrf:t ¼ a þ kEt ðCi:t Þ þ lS bS:i þ εi:t ð28Þ
 E4 ¼  0:0008 b4;p25  b4;p1 12 ¼ 3:645%
Et Ri:t  Rrf:t ¼ a þ kEt ðCi:t Þ þ l1 b1:i þ liL biL:i þ εi:t
The findings presented in Table 6 also supports the sig-
nificance of liquidity risks on asset returns. According to
Model 21, total systematic risk, as a combination of market
and illiquidity risks has a statistically significant effect on
asset returns at BIST in 01.1997e12.2018 period. The results
from the Model 22 also provide strong evidence about the
significance of liquidity risk effect on excess returns. When we
compare the results of the Model 13 and Model 22, we can
clearly see the contribution of illiquidity risk in explaining the
asset returns. While the adjusted coefficient of determination
of the Model 13 is % 36.49, the addition of net illiquidity beta
ðbL:i Þ increases the adjusted R2 to % 46.53. Both Model 21 and
Model 22 show that inclusion of liquidity risk to the CAPM
framework increases the explanation power.
These results may provide further information about the
effect of liquidity risks on returns. The common risk premium
that is generated from the estimated parameter of total sys-
tematic risk ðbS:i Þ, which is 0.0008 (see Table 6) can be used to
calculate the effect of each liquidity risk on asset returns by
using the following equation:

Ex ¼ 8ls :a: bx;p25  bx;p1 :12
<
x ¼ 2 then a ¼ 1 ð30Þ
if
: x ¼ 3 or 4 then a ¼ 1
where, Ex is the effect of liquidity risk x on asset returns, ls is
the risk premium of total systematic risk (0.0008), bx;p25 is the
xth beta coefficient of portfolio 25, bx;p1 is the xth beta co-
efficient of portfolio 1, a parameter is implemented to adjust
the positive and negative effects of illiquidity sensitivity of
asset returns. The results are multiplied by 12 in order to get
ð26Þ the annual effects of each illiquidity betas on asset returns.
The annual returns attributed to the commonality between
portfolio illiquidity and market illiquidity ðE2 Þ, the annual
return attributed to the sensitivity of portfolio return to market
ð27Þ illiquidity ðE3 Þ and the annual return attributed to the sensi-
tivity of portfolio illiquidity to market return ðE4 Þ can be
calculated as follows:

E2 ¼ 0:0008 b2;p25  b2;p1 12 ¼ 3:115% ð31Þ

ð32Þ

ð33Þ
ð29Þ
We can conclude that the covariance between asset's illi-
quidity and the market return is the most important illiquidity
risk with the annual return attribution of 3.645%. This evi-
dence is convenient with the results of Acharya & Pedersen
(2005), and Hangstr€omer, Hanson and Nilsson for US stock
markets. Minovic & Zivkovic (2010) also presented the
dominant role of this type of illiquidity in the Serbian market.
The evidence about the significance of the illiquidity risk in
BIST is particularly important because there is a considerable
amount of research about the validity of CAPM in Turkish
market that present contradictory results. Among the others,
Akdeniz, Salih, & Aydogan (2000) analyzed CAPM in Istanbul
Stock Exchange (ISE) and conducted a test for 1992e1998
period. The results present no evidence about a significant
relation between market betas and asset returns. Another
research by Karan & Karadaglı (2001) tested the CAPM in ISE
in the sample period of 1991e1998 and could not find an evi-
dence about the significant relation between asset returns and
market betas. Altay (2001), tested CAPM and could not find

Table 6
Effects of net illiquidity beta and total systematic risk on asset returns. The table reports estimated parameters, test statistics, probability values and coefficient of
determinations of the OLS regression models. b1;i is the market beta, bS;i is the total systematic risk, bL;i is the net illiquidity beta and Et ðCi:t Þ is the average
portfolio illiquidity.
Model a Et ðCi:t Þ b1:i bS:i biL:i F test R2 Adj R2
21 Coeff. 0.0117 0.0002 0.0008 11.9095 0.5198 0.4762
p-value (0.0000) (0.4210) (0.0195)
22 Coeff. 0.0222 0.0004 0.0370 0.0011 7.9619 0.5321 0.4653
p-value (0.1317) (0.2903) (0.4558) (0.0342)

Please cite this article as: Altay, E., & Çalgıcı, S., Liquidity adjusted capital asset pricing model in an emerging market: Liquidity risk in Borsa Istanbul, Borsa
_
Istanbul Review, https://doi.org/10.1016/j.bir.2019.06.002
 + MODEL
12
E. Altay, S. Çalgıcı / Borsa Istanbul Review xxx (xxxx) xxx
evidence for supporting the existence of beta-expected return
relation in ISE during 1992e200 period. The research by
G€ursoy & Rejepova (2007) also could not present a significant
relation between beta and asset returns in ISE during the
1995e2004 period. Bilgin & Basti (2011), also tested CAPM
and they could not reach a result which can support the relation
between returns and beta coefficients. On the other hand, there
are some other papers implementing different methodologies for
testing CAPM in Turkish stock market which found supporting
evidence about the validity of the model. Among the others,
Tuna & Tuna (2013) tested downside CAPM as well as CAPM in
ISE for the sample period of 1991e2009. They found a signif-
icant effect of beta on asset returns. K€ oseoglu & Mercang€oz
(2013) tested standard and Zero beta CAPM models in ISE for
2002e2006 period and the validity of both models could not
rejected. So, the significance of liquidity risks on excess returns
provide an additional understanding about the risk-return
structure in BIST under the framework of CAPM.
5. Conclusion
We investigated the effect of liquidity risk on asset returns
in an emerging market, BIST, under the LCAPM framework of
Acharya & Pedersen (2005) methodology. The results of the
LCAPM model shows that including illiquidity betas to the
standard model contribute the explanation power of systematic
risks on asset returns.
We analyzed 3 liquidity risks, namely commonality in
liquidity with the market ðb2:i Þ, return sensitivity to market
liquidity ðb3:i Þ and liquidity sensitivity to market returns
ðb4:i Þ as well as market beta ðb1:i Þ. These four beta co-
efficients are generated and employed in various models in
order to explore their significance on asset returns in BIST
during 1997e2018 period. The results present the evidence of
the strong significance of the positive relation between the
covariance between assets' illiquidity as well as market illi-
quidity ðb2 Þ and negative relation between the covariance
between assets' illiquidity and market returns ðb4 Þ on asset
returns in BIST in the sample period. On the other hand,
assets' return sensitivity to the market liquidity ðb3 Þ has a
positive and significant effect on the asset returns although it
is expected to be negative according to the theory. This in-
formation about the structure of the market may be usefull in
investment strategy development under liquid and illiquid
conditions for individual and institutional investors. The
findings may also provide shed light to the policy makers
while they are taking actions about the market liquidity. We
can say that investors require higher returns for the assets
which become illiquid and have high returns when Borsa
Istanbul becomes illiquid. On the other hand the ability of
selling the assets quickly at a low cost and without changing
price becomes more important when the returns in Borsa
Istanbul decreases.
The empirical results provide the evidence about the
importance of liquidity risk on asset returns. The addition of
net illiquidity beta as another source of systematic risk alter
the explanation power of the standard model where market
Please cite this article as: Altay, E., & Çalgıcı, S., Liquidity adjusted capital asset pricing model in an emerging market: Liquidity risk in Borsa Istanbul, Borsa
_
Istanbul Review, https://doi.org/10.1016/j.bir.2019.06.002
_
beta is employed as the only systematic risk. We can conclude
that liquidity is an important driver of the expected returns in
BIST. The evidence about the significance of liquidity risk is
parallel with some other research in emerging markets like the
research of Garnia, Sudarsono, Masyita, & Primiana (2016) in
Indonesian, and Sadaqat & Butt (2017) in Pakistani, Indian
and Brazilian stock markets. The evidence about the validity
of liquidity risk and its contribution to standard CAPM in
BIST as an emerging market can provide a motivation for
further examining the risk return relation in emerging capital
markets in the framework of LCAPM.
Funding
This research did not receive any specific grant from
funding agencies in the public, commercial, or not-for-profit
sectors.
Conflicts of interest
None.
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