Asset Pricing with Liquidity Risk
67 Pages Posted: 11 Nov 2008
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Asset Pricing with Liquidity Risk
Asset Pricing with Liquidity Risk
Asset Pricing with Liquidity Risk
Date Written: July 2003
Abstract
This paper studies equilibrium asset pricing with liquidity risk | the risk arising from unpredictable changes in liquidity over time. It is shown that a security s required return depends on its expected illiquidity and on the covariances of its own return and illiquidity with market return and market illiquidity. This gives rise to a liquidity- adjusted capital asset pricing model. Further, if a security s liquidity is persistent, a shock to its illiquidity results in low contemporaneous returns and high predicted future returns. Empirical evidence based on cross-sectional tests is consistent with liquidity risk being priced.
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