Illiquidity and Portfolio Risk of Thinly-Traded Assets
Posted: 21 May 2019
Date Written: December 1, 2008
Thinly-traded assets exhibit illiquidity and do not fit in the efficient market paradigm. Direct application of classical finance theories to illiquid assets simply ignores the illiquidity risk of thinly-traded assets. Using commercial real estate as a testing ground, this paper develops a new, closed-form ex ante risk metric that converts illiquidity risk and integrates it with real estate price risk. Such integration provides a formal and easy-to-use analytical tool for illiquid asset pricing and enables apples-to-apples comparison between the performances of real estate and financial assets. Using real estate data, we show that the conventional risk metric significantly underestimates the true real estate risk and our finding helps to explain the apparent “risk premium puzzle” in real estate.
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