Asset Prices and Asset Correlations in Illiquid Markets

Abstract

We build a new asset pricing framework to study the effects of aggregate illiquidity on asset prices, volatilities and correlations. The Black-Scholes economy is obtained in our framework as the limiting case of perfectly liquid markets. The model is consistent with empirical studies on the effects of illiquidity on asset returns, volatilities and correlations. We present the model, study its qualitative properties and estimate the stocks' sensitivities to aggregate liquidity (betas) using nine years data for 24 randomly sampled stocks traded on the NYSE. These sensitivity parameters (betas) determine the effect that aggregate illiquidity has on expected returns, volatilities, correlations, CAPM-betas and Sharpe ratios. We find clear capitalization and sector patterns for the liquidity betas.

Keywords: Market Liquidity, Volatilities, Correlations, Asset Pricing, GMM

JEL Classification: G12, G14, C30