This paper presents a simple theoretical model that explains how liquidity risk affects asset prices. The model introduces a liquidity-adjusted capital asset pricing model (CAPM), where a security's required return depends on its expected liquidity, as well as the covariances of its return and liquidity with the market return and liquidity. The model shows that persistent negative shocks to a security's liquidity result in low contemporaneous returns and high predicted future returns. It provides a unified framework for understanding the various channels through which liquidity risk may affect asset prices. The model is based on an overlapping generations economy where risk-averse agents trade securities with varying liquidity. The liquidity-adjusted CAPM is derived explicitly, and the model shows that liquidity predicts future returns and co-moves with contemporaneous returns. The model also highlights three forms of liquidity risk: (i) commonality in liquidity with the market, (ii) return sensitivity to market liquidity, and (iii) liquidity sensitivity to market returns. Empirical results using NYSE and AMEX stocks from 1963 to 1999 show that the liquidity-adjusted CAPM performs better than the standard CAPM in terms of R² and p-values in specification tests. The model has a good fit for portfolios sorted on liquidity, liquidity variation, and size, but cannot explain the cross-sectional returns associated with the book-to-market effect. The results suggest that illiquid securities also have high liquidity risk, consistent with "flight to liquidity" in times of down markets or generally illiquid markets. The model shows that liquidity is persistent, and thus liquidity predicts future returns and co-moves with contemporaneous returns. The empirical analysis suggests that the effects of liquidity level and liquidity risk are separate, although the analysis is made difficult by collinearity. One channel for liquidity risk that has not been treated in the prior literature, namely the covariance between a security's illiquidity and the market return, may be of empirical importance. The paper is organized as follows: Section 2 describes the economy, Section 3 derives the liquidity-adjusted CAPM and outlines how liquidity predicts and co-moves with returns, Section 4 contains an empirical analysis, and Section 5 concludes. Proofs are in the Appendix.This paper presents a simple theoretical model that explains how liquidity risk affects asset prices. The model introduces a liquidity-adjusted capital asset pricing model (CAPM), where a security's required return depends on its expected liquidity, as well as the covariances of its return and liquidity with the market return and liquidity. The model shows that persistent negative shocks to a security's liquidity result in low contemporaneous returns and high predicted future returns. It provides a unified framework for understanding the various channels through which liquidity risk may affect asset prices. The model is based on an overlapping generations economy where risk-averse agents trade securities with varying liquidity. The liquidity-adjusted CAPM is derived explicitly, and the model shows that liquidity predicts future returns and co-moves with contemporaneous returns. The model also highlights three forms of liquidity risk: (i) commonality in liquidity with the market, (ii) return sensitivity to market liquidity, and (iii) liquidity sensitivity to market returns. Empirical results using NYSE and AMEX stocks from 1963 to 1999 show that the liquidity-adjusted CAPM performs better than the standard CAPM in terms of R² and p-values in specification tests. The model has a good fit for portfolios sorted on liquidity, liquidity variation, and size, but cannot explain the cross-sectional returns associated with the book-to-market effect. The results suggest that illiquid securities also have high liquidity risk, consistent with "flight to liquidity" in times of down markets or generally illiquid markets. The model shows that liquidity is persistent, and thus liquidity predicts future returns and co-moves with contemporaneous returns. The empirical analysis suggests that the effects of liquidity level and liquidity risk are separate, although the analysis is made difficult by collinearity. One channel for liquidity risk that has not been treated in the prior literature, namely the covariance between a security's illiquidity and the market return, may be of empirical importance. The paper is organized as follows: Section 2 describes the economy, Section 3 derives the liquidity-adjusted CAPM and outlines how liquidity predicts and co-moves with returns, Section 4 contains an empirical analysis, and Section 5 concludes. Proofs are in the Appendix.