Pricing Liquidity Risk in the Korean Corporate Bond Market*

Abstract This study investigates the pricing of liquidity risk in the Korean corporate bond market. We use three different liquidity factors — namely, aggregate market liquidity, liquidity innovation, and predicted liquidity. The empirical results show that, while a liquidity premium exists in the Korean corporate bond market when measured by the market liquidity factor, a liquidity discount occurs when measured by the predicted liquidity factor. Drawing on prior studies, we further describe that the lower (higher) returns for portfolios with a high sensitivity to unexpected liquidity shocks may be attributable to the infrequent (frequent) trading of AAA(A)‐rated bonds in the Korean market. Finally, our findings suggest that while a liquidity premium exists in expectation, investors are penalized for taking predicted liquidity risks in the Korean corporate bond market.