Asset Pricing with Heterogeneous Beliefs and Endogenous Liquidity

Abstract:     
This article studies a dynamic general-equilibrium economy in which one population of optimistic investors is subject to endogenous liquidity constraints, that prevent default due to ex-ante limited commitment. We find a joint feedback effect between sentiment driven by optimistic investors and endogenous liquidity: lower sentiment decreases liquidity, and lower liquidity increases sentiment. Even though liquidity decreases are predictable they are priced, because they impact the magnitude of the market price of sentiment risk. The joint feedback effect between sentiment and endogenous liquidity produces rich dynamics for stock return and its volatility. We show that the model can quantitatively generate volatility clustering at different frequencies, asymmetry in the stock-return volatility relationship, and the negative pricing of stock-return volatility in expected stock return. In addition, the model provides unique predictions on the co-movement of endogenous liquidity, the equity premium, the interest rate, and stock-return volatility at different frequencies.

Number of Pages in PDF File: 53

Keywords: Heterogeneous Beliefs, Liquidity, Default, Volatility

JEL Classification: G10,G12

working papers series