31-05-2013, 02:50 PM
Liquidity risk, liquidity demand of investors and asset pricing
ABSTRACT
Among the field of asset pricing theory, the theoretical significance of market liquidity risk premium is a
hot topic. This paper decomposes market liquidity risk into exogenous and endogenous liquidity risk,
and introduces liquidity demand as a state variable, giving rise to the random holding horizon, and
develops a liquidity risk-adjusted capital asset pricing model. Besides agreement with the previous
theoretical literatures about the effect of exogenous liquidity risk on asset pricing, we find that different
elasticity value of price impact can make a cross-sectional dispersion in required return for the level of
liquidity and market liquidity risk. The state variable of liquidity demand affects market liquidity risk
premium increasingly, and could induce the known time-varying phenomenon of liquidity risk premium.
INTRODUCTION
Liquidity is an asset’s ability to be sold without causing a
significant movement in the price and with minimum loss
of value. More liquid asset leads to easier transaction,
more stable price and low transaction cost. The unpredictable
change in liquidity could be called liquidity risk.
For investor, real market is far from the perfect market
with no transaction cost and everlasting equilibrium from
classical asset pricing model. So, it is reasonable to take
liquidity and liquidity risk into consideration.
LITERATURE REVIEW
Chordia et al. (2000) had asserted that if liquidity shock in
market cannot be diversified, stock which is more
sensitivity to the total market liquidity would be required
more return. Pastor and Stambaugh (2003) gave the
earliest positive respond. They set the liquid b as the
individual stock sensitivity ratio to the market portfolio
liquidity perturbation. Based on the data in U.S stock
market from 1966 to 1999, they discovered the average
annual return of portfolio with highest liquid b is 7.5%
higher than that of the portfolio with lowest liquid b, after
adjusting for the three factors of Fama-French and
momentum factor. Eckbo and Norli (2002), Wang (2003),
Sadka (2004), and Acharya and Pedersen (2005) also
got the similar stock market cross-section result. For
example, Acharya and Pedersen (2005) who did
empirical research on the performance of U.S. NYSE and
AMEX during 1963 and 1999, found that the R2 in liquidity
risk-adjusted CAPM is much higher than classical R2.
Based on adjusted CAPM, adding market b and three b
on liquidity together, the total b had a significant premium.
Avramov et al. (2002) found that the portfolio with liquidity
as one risk factor is more close to multi-factors unbiased
variance frontier by Merton’s ICAPM. So adding liquidity
risk into consideration would diminish pricing error.
Conclusion
Liquidity and its risk are usually ignored in classical asset
pricing equilibrium model. But in reality, liquidity risk is
one of the prime risks for investors, especially institutional
investors. In asset pricing model, rational investor would
ask for appropriate risk compensation. In this paper, a
liquidity risk-adjusted asset pricing model is given and the
systematic part of liquidity risk would affect asset price
and expected return. At the same time, we prove that
investor would ask for premium for expected liquidity.