Stock and Bond Liquidity and its Effect on Prices and Financial Policies

Financial Markets and Portfolio Management, Vol. 20, No. 1, pp. 19-32, 2006

Posted: 4 Apr 2006

See all articles by Yakov Amihud

Yakov Amihud

New York University - Stern School of Business

Haim Mendelson

Stanford University - Stanford Graduate School of Business

Abstract

An asset is liquid if it can be traded at the prevailing market price quickly and at low cost. We show that in addition to risk, liquidity affects asset prices and returns. Theories of asset pricing suggest that the expected return on an asset is increasing in its risk, because risk-averse investors require a compensation for bearing more risk. Because investors are also averse to the costs of illiquidity and want to be compensated for bearing them, asset returns are increasing in illiquidity. Thus, asset prices should depend on two asset characteristics: risk and liquidity. This paper surveys research on the effects of liquidity on asset prices and returns. We find that liquidity is an important factor in capital asset pricing.

Keywords: Market efficiency, liquidity risk premia, asset prices

JEL Classification: G12, G14

Suggested Citation

Amihud, Yakov and Mendelson, Haim, Stock and Bond Liquidity and its Effect on Prices and Financial Policies. Financial Markets and Portfolio Management, Vol. 20, No. 1, pp. 19-32, 2006, Available at SSRN: https://ssrn.com/abstract=894246

Yakov Amihud (Contact Author)

New York University - Stern School of Business ( email )

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Haim Mendelson

Stanford University - Stanford Graduate School of Business ( email )

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HOME PAGE: http://https://www.gsb.stanford.edu/faculty-research/faculty/haim-mendelson

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