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Stock Market Crises, Background Risk and Liquidity PremiumSergey IsaenkoConcordia University, Quebec - Department of Finance Rui ZhongConcordia University, Quebec - John Molson School of Business January 5, 2011 Abstract: We analyze a portfolio optimization problem for a long-term investor in the presence of stock market crises. A crisis includes a crash of the stock market price, a sharp increase of its volatility and dramatic deterioration of liquidity. We model the stock market illiquidity by means of convex transaction costs that mimic the presence of an effective bid-ask spread that increases with the size of a trade. We find that the existence of stock market crises results in a significant liquidity premium. Furthermore, the presence of background risk has a negative impact on the liquidity premium even if the correlation between the stock market returns and background risk is very high.
Number of Pages in PDF File: 30 Keywords: Portfolio Choice, Liquidity JEL Classification: G11 working papers seriesDate posted: January 18, 2011 ; Last revised: February 21, 2012Suggested CitationContact Information
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