Capital Asset Market Equilibrium With Liquidity Risk, Trading Constraints, and Asset Price Bubbles

40 Pages Posted: 30 Jan 2018

See all articles by Robert A. Jarrow

Robert A. Jarrow

Cornell University - Samuel Curtis Johnson Graduate School of Management

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

Suggested Citation

Jarrow, Robert A., Capital Asset Market Equilibrium With Liquidity Risk, Trading Constraints, and Asset Price Bubbles (December 15, 2017). Available at SSRN: https://ssrn.com/abstract=3107176 or http://dx.doi.org/10.2139/ssrn.3107176

Robert A. Jarrow (Contact Author)

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Department of Finance
Ithaca, NY 14853
United States
607-255-4729 (Phone)
607-254-4590 (Fax)

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