The role of liquidity factor in explaining the cross-section of stock returns: New evidence from Tehran Stock Exchange

This paper examines the role of liquidity factor in explaining the cross-section of stock returns of firms listed at Tehran Stock Exchange. The regression results of CAPM, Liu's two-factor model, the Fama-French three-factor model, and a Four-factor model on eight portfolios formed by Size, B/M Ratio, and Liquidity show that the two-factor (market and liquidity) model performs better in explaining the cross-section of stock returns than the CAPM but not the Fama-French three-factor model. Adding liquidity premium to Fama-French three-factor model improves notably the adjusted R square of the model implying that all four factors of market, size, value, and liquidity play a significant role in explaining stock returns. The results are robust to sensitivity analyses for up and down market conditions and seasonal behavior.