Market-Wide Illiquidity and the Volatility of a Model-Free Stochastic Discount Factor
58 Pages Posted: 9 Jun 2020 Last revised: 26 Oct 2020
Date Written: October 19, 2020
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: Suggested Citation