Is Market Volatility Systematically Priced While Illiquidity Is Only Priced on the Down-Side?

43 Pages Posted: 26 Feb 2016 Last revised: 21 Aug 2016

See all articles by Peter L. Swan

Peter L. Swan

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

Date Written: April 25, 2016


I show in a 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 in the absence of excess short-selling costs. This is because 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, I 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 non-binding but higher short-selling costs that steepen the supply response to adverse demand shocks, can illiquidity be priced and a number of other anomalies explained. I reconcile my findings with Amihud and Mendelson’s (1986) treatment of the buyer by adding in the seller’s perspective which provides the necessary theoretical underpinnings to explain the asymmetric empirical findings of Brennan, Chordia, Subrahmanyam, and Tong (2012), Brennan, Huh, and Subrahmanyam (2013, 2015) and several others.

Keywords: equity-premium puzzle, illiquidity premium, liquidity, short-sale, volatility risk

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

Suggested Citation

Swan, Peter Lawrence, Is Market Volatility Systematically Priced While Illiquidity Is Only Priced on the Down-Side? (April 25, 2016). 29th Australasian Finance and Banking Conference 2016, Available at SSRN: or

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
St Lucia, 4071 Brisbane


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