Liquidity and Asset Prices

96 Pages Posted: 15 Jun 2010

See all articles by Yakov Amihud

Yakov Amihud

New York University - Stern School of Business

Haim Mendelson

Stanford University - Stanford Graduate School of Business

Lasse Heje Pedersen

AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; New York University (NYU); Centre for Economic Policy Research (CEPR)

Date Written: June 14, 2010

Abstract

We review the theories on how liquidity affects the required returns of capital assets and the empirical studies that test these theories. The theory predicts that both the level of liquidity and liquidity risk are priced, and empirical studies find the effects of liquidity on asset prices to be statistically significant and economically important, controlling for traditional risk measures and asset characteristics. Liquidity-based asset pricing empirically helps explain (1) the cross-section of stock returns, (2) how a reduction in stock liquidity result in a reduction in stock prices and an increase in expected stock returns, (3) the yield differential between on- and off-the-run Treasuries, (4) the yield spreads on corporate bonds, (5) the returns on hedge funds, (6) the valuation of closed-end funds, and (7) the low price of certain hard-to-trade securities relative to more liquid counterparts with identical cash flows, such as restricted stocks or illiquid derivatives. Liquidity can thus play a role in resolving a number of asset pricing puzzles such as the small-firm effect, the equity premium puzzle, and the risk-free rate puzzle.

Suggested Citation

Amihud, Yakov and Mendelson, Haim and Pedersen, Lasse Heje, Liquidity and Asset Prices (June 14, 2010). Foundations and Trends in Finance, Vol. 1, No. 4, 2005, Available at SSRN: https://ssrn.com/abstract=1625020

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

Lasse Heje Pedersen

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

New York University (NYU) ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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