Expected Returns and Liquidity Risk: Does Entrepreneurial Income Matter?

Abstract

This paper studies the effects of jointly incorporating liquidity risk and non-tradeable wealth in a single asset pricing equation. First, I propose an overlapping-generations model with random endowment shocks and liquidity risk, evaluating their joint impact on expected returns. The model presents a single-factor asset pricing equation, with a new term capturing the covariance between assets' liquidities and non-tradeable wealth. In this economy, assets with higher liquidity or returns when non-tradeable wealth is low command lower expected returns. Second, I investigate whether risks associated with liquidity are priced after including non-tradeable wealth due to entrepreneurial income. I test the model on equally weighted and value-weighted portfolios, sorted by illiquidity levels, illiquidity variation and size, using US stock data from January 1962 to December 2004. The extra terms due to entrepreneurial income reduce liquidity risk premium by almost 40%, with an impact of -0.45% per year on expected returns of value-weighted illiquidity-sorted portfolios. Overall, liquidity risk as a whole has a yearly premium equal to 1.06%. However, liquidity levels are much more important and have a premium of 6.14% per year, contributing to most of the explanatory gains of the model.