Asset Pricing with Liquidity Risk
47 Pages Posted: 11 Jan 2005
Date Written: October 2004
This Paper solves explicitly a simple equilibrium asset pricing model with liquidity risk - the risk arising from unpredictable changes in liquidity over time. In our liquidity-adjusted capital asset pricing model, a security's required return depends on its expected liquidity as well as on the covariances of its own return and liquidity with market return and market liquidity. In addition, the model shows how a negative shock to a security's liquidity, if it is persistent, results in low contemporaneous returns and high predicted future returns. The model provides a simple, unified framework for understanding the various channels through which liquidity risk may affect asset prices. Our empirical results shed light on the total and relative economic significance of these channels.
Keywords: Liquidity, liquidity risk, asset pricing, frictions, transaction costs
JEL Classification: G00, G10, G12
Suggested Citation: Suggested Citation