DP3749 Asset Pricing with Liquidity Risk

Author(s): Viral V. Acharya , Lasse Heje Pedersen

Publication Date: February 2003

Keyword(s): liquidity , liquidity risk , capital asset pricing model (CAPM) , liquidity premium , equilibrium asset pricing

JEL(s): D50 , G11 , G12 , G30

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP3749.asp

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.