Capital Asset Market Equilibrium With Liquidity Risk, Trading Constraints, and Asset Price Bubbles
40 Pages Posted: 30 Jan 2018
Date Written: December 15, 2017
Abstract
This paper derives an equilibrium asset pricing model with endogenous liquidity risk, trading constraints, and asset price bubbles. Liquidity risk is modeled as a stochastic quantity impact on the price from trading, where the size of the impact depends on trade size. Asset price bubbles are generated by the existence of trading constraints, e.g. short sale prohibitions and margin requirements. Under a strong set of assumptions, we prove a unique equilibrium price process exists for our economy. We characterize the market’s state price density, which enables the derivation of the risk-return relation for the stock’s expected return including both liquidity risk and asset price bubbles. This yields a generalized intertemporal and consumption CAPM for our economy. In contrast to the traditional models without liquidity risk or asset price bubbles, there are additional systematic liquidity risk and asset price bubble factors which are related to the stock return’s covariation with liquidity risk and asset price bubbles.
Keywords: Liquidity risk, trading constraints, asset price bubbles, asset
JEL Classification: G11, G12, D53
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