DP4718 Asset Pricing with Liquidity Risk

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

Publication Date: October 2004

Keyword(s): liquidity , liquidity risk , asset pricing , frictions , transaction costs

JEL(s): G00 , G10 , G12

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP4718.asp

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.