Pricing Liquidity Risk with Heterogeneous Investment Horizons
Cass Business School; Centre for Economic Policy Research (CEPR)
Tilburg University - Department of Finance; CentER Tilburg University
University of Amsterdam - Finance Group; Tilburg University - Department of Finance
CEPR Discussion Paper No. DP8710
We develop a liquidity-based asset pricing model featuring investors with heterogeneous investment horizons and stochastic transaction costs. In an equilibrium where all investors invest in all assets (integration), we find that the existence of investors with heterogeneous horizons, as opposed to homogeneous horizons, reduces the importance of liquidity risk relative to the standard CAPM market risk and generates a more complex effect of expected liquidity. In an equilibrium where short-term investors do not invest in some more illiquid assets (partial segmentation), our model generates an additional segmentation premium for these assets. We estimate the model for the cross-section of U.S. stocks using GMM and find that our heterogeneous-horizon asset pricing model fares better than a standard liquidity-adjusted CAPM. The segmented version of our model delivers the best cross-sectional fit and generates a substantial effect of expected liquidity on expected returns.
Number of Pages in PDF File: 49
Keywords: investment horizon, liquidity risk
JEL Classification: G11, G12working papers series
Date posted: December 22, 2011
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