Liquidity and Asset Prices
New York University - Stern School of Business
Stanford University - Stanford Graduate School of Business
Lasse Heje Pedersen
New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)
June 14, 2010
Foundations and Trends in Finance, Vol. 1, No. 4, 2005
We review the theories on how liquidity affects the required returns of capital assets and the empirical studies that test these theories. The theory predicts that both the level of liquidity and liquidity risk are priced, and empirical studies find the effects of liquidity on asset prices to be statistically significant and economically important, controlling for traditional risk measures and asset characteristics. Liquidity-based asset pricing empirically helps explain (1) the cross-section of stock returns, (2) how a reduction in stock liquidity result in a reduction in stock prices and an increase in expected stock returns, (3) the yield differential between on- and off-the-run Treasuries, (4) the yield spreads on corporate bonds, (5) the returns on hedge funds, (6) the valuation of closed-end funds, and (7) the low price of certain hard-to-trade securities relative to more liquid counterparts with identical cash flows, such as restricted stocks or illiquid derivatives. Liquidity can thus play a role in resolving a number of asset pricing puzzles such as the small-firm effect, the equity premium puzzle, and the risk-free rate puzzle.
Number of Pages in PDF File: 96Accepted Paper Series
Date posted: June 15, 2010
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