Stock Market Crises, Background Risk and Liquidity Premium
Concordia University, Quebec - Department of Finance
Concordia University, Quebec - John Molson School of Business
January 5, 2011
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: G11working papers series
Date posted: January 18, 2011 ; Last revised: February 21, 2012
© 2013 Social Science Electronic Publishing, Inc. All Rights Reserved.
This page was processed by apollo3 in 0.422 seconds