Asset Pricing with Downside Liquidity Risks

Abstract

We develop a parsimonious liquidity-adjusted downside capital asset pricing model to investigate if phenomena such as downward liquidity spirals and flights to liquidity impact expected asset returns. We find strong empirical support for the model. Downside liquidity risk (sensitivity of stock liquidity to negative market returns) has an economically meaningful return premium that is ten times larger than its symmetric analogue. The expected liquidity level and downside market risk are also associated with meaningful return premiums. Downside liquidity risk and its associated premium are higher during periods of low market-wide liquidity, and for stocks that are relatively small, illiquid, volatile, and have high book-to-market ratios. These results are consistent with investors requiring compensation for holding assets susceptible to adverse liquidity phenomena. Our findings suggest that mitigation of downside liquidity risk can lower firms’ cost of capital.

Keywords: liquidity risk, liquidity spiral, conditional moment, pricing kernel, downside risk

JEL Classification: G12