Market-Wide Illiquidity and the Volatility of a Model-Free Stochastic Discount Factor

58 Pages Posted: 9 Jun 2020 Last revised: 26 Oct 2020

See all articles by David Abad

David Abad

Universidad de Alicante

Belen Nieto

University of Alicante

Roberto Pascual

Universidad de las Islas Baleares

Gonzalo Rubio

Universidad CEU Cardenal Herrera

Date Written: October 19, 2020

Abstract

We show that illiquidity risk matters for asset pricing independently of the specific functional form of the liquidity-based asset pricing model. Employing a non-parametric model-free stochastic discount factor (SDF), estimated using different sets of portfolio returns coming from both the stock and the corporate bond markets, we show that market-wide illiquidity affects positive and significantly the volatility of the SDF. This finding is robust to the use of alternative market-wide illiquidity metrics and persists after we control for GARCH effects on the short-term component of the SDF’s volatility. Overall, our analysis shows that market-wide illiquidity is a relevant driver of the time-varying behavior of the assets’ risk premium.

Keywords: stochastic discount factor, market-wide illiquidity, illiquidity risk, illiquidity spillovers, asset pricing

JEL Classification: G12, G14

Suggested Citation

Abad, David and Nieto, Belen and Pascual Gascó, Roberto and Rubio, Gonzalo, Market-Wide Illiquidity and the Volatility of a Model-Free Stochastic Discount Factor (October 19, 2020). Available at SSRN: https://ssrn.com/abstract=3601732 or http://dx.doi.org/10.2139/ssrn.3601732

David Abad

Universidad de Alicante ( email )

Campus de San Vicente
Carretera San Vicente del Raspeig
San Vicente del Raspeig, 03690
Spain

Belen Nieto (Contact Author)

University of Alicante ( email )

Campus de San Vicente
Carretera San Vicente del Raspeig
San Vicente del Raspeig, Alicante 03690
Spain

Roberto Pascual Gascó

Universidad de las Islas Baleares ( email )

Ctra. de Valldemossa km 7,5
Departamento de Economia y Empresa
Palma, Baleares
Spain
+34 971 17 13 29 (Phone)
+34 971 17 23 89 (Fax)

Gonzalo Rubio

Universidad CEU Cardenal Herrera ( email )

Comissari, 1
Elche, Alicante
Spain

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