Liquidity and Expected Returns in a Multi-Factor Asset Pricing Model
University of Texas at Austin - Department of Finance
September 30, 2010
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.
Number of Pages in PDF File: 55working papers series
Date posted: March 17, 2009 ; Last revised: October 6, 2010
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