DP3749 Asset Pricing with Liquidity Risk

Author(s): Viral V. Acharya, Lasse Heje Pedersen
Publication Date: February 2003
Keyword(s): capital asset pricing model (CAPM), equilibrium asset pricing, liquidity, liquidity premium, liquidity risk
JEL(s): D50, G11, G12, G30
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3749

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.