Asset Market Equilibrium with Liquidity Risk
36 Pages Posted: 2 Sep 2015 Last revised: 13 Dec 2017
Date Written: December 6, 2017
Abstract
This paper derives an equilibrium asset pricing model with liquidity risk. Liquidity risk is modeled as a stochastic quantity impact on the price from trading, where the size of the impact depends on trade size. Under a mild set of assumptions, we prove that an equilibrium price process exists for our economy and we characterize the market’s state price density, which enables the derivation of the risk-return relation for the stock’s expected return including liquidity risk. In contrast to the traditional models without liquidity risk, there is an additional systematic liquidity risk factor which is related to the stock return’s covariation with the market’s stochastic liquidity cost. Traditional transaction costs are a special case of our formulation.
Keywords: Liquidity risk, asset market equilibrium, systematic risk, intertemporal CAPM, consumption CAPM
JEL Classification: G11, G12, D53
Suggested Citation: Suggested Citation