Liquidity Premia in Dynamic Bargaining Markets
37 Pages Posted: 3 Nov 2008
Date Written: May 2005
This paper develops a search-theoretic model of the cross-sectional distribution of asset returns, abstracting from risk premia and focusing exclusively on liquidity. I derive a float-adjusted return model (FARM),explainingthe pricing of liquidity with a simple linear formula: In equilibrium, the liquidity spread of an asset is proportional to the inverse of its free float, the portion of its market capitalization available for sale. This suggests that the free float is an appropriate measure of liquidity, consistent with the linear specifications commonly estimated in the empirical literature.The qualitative predictions of the model corroborate much of the empirical evidence.
Keywords: Liquidity premia, Search
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