Is Liquidity Largely Unpriced While Market Volatility is Systematically Priced?

61 Pages Posted: 15 Jan 2016 Last revised: 11 Feb 2016

See all articles by Andre Levy

Andre Levy

UNSW Business School

Peter L. Swan

University of New South Wales (UNSW Sydney; Financial Research Network (FIRN)

Date Written: February 11, 2016


We show in a fairly general setting of a buyer and seller with the same preferences trading two related assets so as to share volatility risk that illiquidity and virtually all impediments to trade cannot be priced. This is because the buying and selling counterparties must both be optimizing. The buyer values the asset at the low Bid-price and seller at the high Ask-price. When market clears, the buyer and seller order-flows cancel out leaving the midpoint price independent of the tax wedge. Using this admittedly “stylized” model and very modest CARA and CRRA risk preferences, we generate Mehra and Prescott’s (1985) equity premium of about 8% and negligible yield on T-bills, together with the observed turnovers of both T-Bills and equity securities, to show that market volatility is systematically priced. Moreover, only in the presence of binding short-selling restrictions that effectively eliminate the supply responses to adverse demand shocks, can illiquidity be priced and a number of other anomalies explained. We reconcile our findings with Amihud and Mendelson’s (1986) treatment of the buyer by adding in the essential seller’s perspective which only then provides the necessary theoretical underpinnings to explain the asymmetric empirical findings of Brennan, Chordia, Subrahmanyam, and Tong (2012) and Brennan, Huh, and Subrahmanyam (2015).

Keywords: equity-premium puzzle, illiquidity premium, liquidity, trading, volatility risk

JEL Classification: G12, G11, G310, C61, D91, D92

Suggested Citation

Levy, Andre and Swan, Peter Lawrence, Is Liquidity Largely Unpriced While Market Volatility is Systematically Priced? (February 11, 2016). Available at SSRN: or

Andre Levy

UNSW Business School ( email )

UNSW Business School
High St
Sydney, NSW 2052

Peter Lawrence Swan (Contact Author)

University of New South Wales (UNSW Sydney ( email )

School of Banking and Finance
UNSW Business School
Sydney NSW, NSW 2052
+61 2 9385 5871 (Phone)
+61 2 9385 6347 (Fax)

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Financial Research Network (FIRN)

C/- University of Queensland Business School
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