Asset Pricing in Markets with Illiquid Assets
Francis A. Longstaff
University of California, Los Angeles (UCLA) - Finance Area; National Bureau of Economic Research (NBER)
AFA 2006 Boston Meetings Paper
Many important classes of assets are illiquid in the sense that they cannot always be traded immediately. Thus, a portfolio position in these types of illiquid investments becomes at least temporarily irreversible. We study the asset-pricing implications of illiquidity in a two-asset exchange economy with heterogeneous agents. In this market, one asset is always liquid. The other asset can be traded initially, but then not again until after a "blackout" period. Illiquidity has a dramatic effect on optimal portfolio decisions. Agents abandon diversification as a strategy and choose highly polarized portfolios instead. The value of liquidity can represent a large portion of the equilibrium price of an asset. We present examples in which a liquid asset can be worth up to 25 percent more than an illiquid asset even though both have identical cash flow dynamics. We also show that the expected return and volatility of an asset can change significantly as the asset becomes relatively more liquid.
Number of Pages in PDF File: 40
Keywords: Liquidity, Illiquid, Asset pricing, Heterogenous agents
JEL Classification: G12working papers series
Date posted: March 24, 2005
© 2014 Social Science Electronic Publishing, Inc. All Rights Reserved.
This page was processed by apollo8 in 0.375 seconds