We investigate time variations in expected illiquidity premium adopting a two-state Markov switching model. We find that sensitivities of liquidity-sorted portfolio returns on business-cycle-variables are significantly different across the high and low volatility states, and the asymmetry is especially pronounced in the least liquid portfolio. As a result, strong time variations in the expected illiquidity premium are observed. The facts that (1) the expected illiquidity premium increases rapidly during recessions, but decreases during expansions, and (2) it has negative correlations with procyclical macroeconomic variables indicate that the expected illiquidity premium is countercyclical. Our findings are robust to the choice of liquidity measures.
JEL classification: G14
Keywords: Markov switching model; Illiquidity premium; Time-varying expected returns; Business-cycle-variable
