This paper presents a theoretical model that explains how asset prices are affected by liquidity risk and commonality in liquidity. The model, a liquidity-adjusted capital asset pricing model (CAPM), shows that a security's required return depends on its expected liquidity and the covariances of its return and liquidity with the market return and liquidity. The model provides a unified framework for understanding various channels through which liquidity risk may impact asset prices. Empirical results using NYSE and AMEX stocks from 1963 to 1999 support the model's predictions, showing that illiquid securities have high liquidity risk and that the total effect of liquidity level and liquidity risk is significant. The model also predicts that liquidity predicts future returns and co-moves with contemporaneous returns, which is consistent with empirical findings. The paper concludes by offering insights into the economic significance of liquidity level and different forms of liquidity risk.This paper presents a theoretical model that explains how asset prices are affected by liquidity risk and commonality in liquidity. The model, a liquidity-adjusted capital asset pricing model (CAPM), shows that a security's required return depends on its expected liquidity and the covariances of its return and liquidity with the market return and liquidity. The model provides a unified framework for understanding various channels through which liquidity risk may impact asset prices. Empirical results using NYSE and AMEX stocks from 1963 to 1999 support the model's predictions, showing that illiquid securities have high liquidity risk and that the total effect of liquidity level and liquidity risk is significant. The model also predicts that liquidity predicts future returns and co-moves with contemporaneous returns, which is consistent with empirical findings. The paper concludes by offering insights into the economic significance of liquidity level and different forms of liquidity risk.