Working Paper: CEPR ID: DP4718
Authors: Viral V. Acharya; Lasse Heje Pedersen
Abstract: This Paper solves explicitly a simple equilibrium asset pricing model with liquidity risk ? the risk arising from unpredictable changes in liquidity over time. In our liquidity-adjusted capital asset pricing model, a security?s required return depends on its expected liquidity as well as on the covariances of its own return and liquidity with market return and market liquidity. In addition, the model shows how a negative shock to a security?s liquidity, if it is persistent, results in low contemporaneous returns and high predicted future returns. The model provides a simple, unified framework for understanding the various channels through which liquidity risk may affect asset prices. Our empirical results shed light on the total and relative economic significance of these channels.
Keywords: Asset Pricing; Frictions; Liquidity; Liquidity Risk; Transaction Costs
JEL Codes: G0; G10; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| covariance between a security's illiquidity and market illiquidity (cov(ci, cm)) (G10) | expected returns (G17) |
| covariance between a security’s return and market liquidity (cov(ri, cm)) (G10) | expected returns (G17) |
| covariance between a security's illiquidity and market returns (cov(ci, rm)) (G10) | expected returns (G17) |