DP4718 Asset Pricing with Liquidity Risk

Author(s): Viral V Acharya, Lasse Heje Pedersen
Publication Date: October 2004
Keyword(s): asset pricing, frictions, liquidity, liquidity risk, transaction costs
JEL(s): G00, G10, G12
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4718

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.