Working Paper: CEPR ID: DP3749
Authors: Viral V. Acharya; Lasse Heje Pedersen
Abstract: This Paper studies equilibrium asset pricing with liquidity risk (the risk arising from unpredictable changes in liquidity over time). It is shown that the required return on a security depends on its expected illiquidity, the covariances of its own return, 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.
Keywords: Capital Asset Pricing Model; CAPM; Equilibrium Asset Pricing; Liquidity; Liquidity Premium; Liquidity Risk
JEL Codes: D50; G11; G12; G30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| expected illiquidity + net beta (G12) | required return (Y20) |
| market illiquidity (G10) | return premium for illiquid securities (G19) |
| market downturn (G10) | lower expected returns on liquid securities (G12) |
| expected illiquidity (G33) | required return (Y20) |
| liquidity risk (G33) | asset returns (G19) |