The Liquidity Risk Adjusted Epstein-Zin Model

Abstract

In this paper, we propose a liquidity risk adjustment to the Epstein and Zin (1989, 1991) model and assess the adjusted model's performance against the traditional consumption pricing models. We show that liquidity is a significant risk factor and it adds considerable explanatory power to the model. The liquidity-adjusted model produces both a higher cross-sectional R2 and a smaller Hansen and Jagannathan (1997) distance than the traditional CCAPM and the original Epstein-Zin model. Overall, we show that liquidity is both a priced factor and a key contributor to the adjusted Epstein-Zin model's goodness-of-fit.

Keywords: Liquidity risk; Consumption-based asset pricing; Model performance

JEL Classification: G12; G14