Asset Pricing with Liquidity Risk

Abstract:     
This paper studies equilibrium asset pricing with liquidity risk - the risk arising from unpredictable changes in liquidity over time. It is shown that a security's required return depends on its expected illiquidity and on the covariances of its own return and illiquidity with market return and market illiquidity. This gives rise to a liquidity-adjusted capital asset pricing model. Further, if a security's liquidity is persistent, a shock to its illiquidity results in low contemporaneous returns and high predicted future returns. Empirical evidence based on cross-sectional tests is consistent with liquidity risk being priced.

Number of Pages in PDF File: 58

Keywords: liquidity risk, asset pricing

JEL Classification: G1, G12

working papers series