Asset Pricing in Markets with Illiquid Assets

40 Pages Posted: 24 Mar 2005  

Francis A. Longstaff

University of California, Los Angeles (UCLA) - Finance Area; National Bureau of Economic Research (NBER)

Date Written: January 2005

Abstract

Many important classes of assets are illiquid in the sense that they cannot always be traded immediately. Thus, a portfolio position in these types of illiquid investments becomes at least temporarily irreversible. We study the asset-pricing implications of illiquidity in a two-asset exchange economy with heterogeneous agents. In this market, one asset is always liquid. The other asset can be traded initially, but then not again until after a "blackout" period. Illiquidity has a dramatic effect on optimal portfolio decisions. Agents abandon diversification as a strategy and choose highly polarized portfolios instead. The value of liquidity can represent a large portion of the equilibrium price of an asset. We present examples in which a liquid asset can be worth up to 25 percent more than an illiquid asset even though both have identical cash flow dynamics. We also show that the expected return and volatility of an asset can change significantly as the asset becomes relatively more liquid.

Keywords: Liquidity, Illiquid, Asset pricing, Heterogenous agents

JEL Classification: G12

Suggested Citation

Longstaff, Francis A., Asset Pricing in Markets with Illiquid Assets (January 2005). AFA 2006 Boston Meetings Paper. Available at SSRN: https://ssrn.com/abstract=687298 or http://dx.doi.org/10.2139/ssrn.687298

Francis A. Longstaff (Contact Author)

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-2218 (Phone)
310-206-5455 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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