Liquidity and Expected Returns in a Multi-Factor Asset Pricing Model
55 Pages Posted: 17 Mar 2009 Last revised: 6 Oct 2010
Date Written: September 30, 2010
Abstract
Several empirical studies find that illiquid firms have higher expected returns than liquid firms. I argue that this result is a puzzle that has not been resolved yet. The liquidity premium is puzzling since investors can circumvent low liquidity by trading diversified funds of illiquid firms. I develop a model that shows how a combination of cross-sectional differences in liquidity and short sale constraints generates a risk premium for illiquid firms despite the ability of investors to trade illiquid firms in large liquid baskets.
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