We review the theories on how liquidity affects the required returns of capital assets and the empirical studies that test these theories. The theory predicts that both the level of liquidity and liquidity risk are priced, and empirical studies find the effects of liquidity on asset prices to be statistically significant and economically important, controlling for traditional risk measures and asset characteristics. Liquidity-based asset pricing empirically helps explain (1) the cross-section of stock returns, (2) how a reduction in stock liquidity result in a reduction in stock prices and an increase in expected stock returns, (3) the yield differential between on- and off-the-run Treasuries, (4) the yield spreads on corporate bonds, (5) the returns on hedge funds, (6) the valuation of closed-end funds, and (7) the low price of certain hard-to-trade securities relative to more liquid counterparts with identical cash flows, such as restricted stocks or illiquid derivatives. Liquidity can thus play a role in resolving a number of asset pricing puzzles such as the small-firm effect, the equity premium puzzle, and the risk-free rate puzzle.

Liquidity and Asset Prices

Liquidity and Asset Pricing

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Determinants of bank credit growth in Australia: Effects of securitisation and the Global Financial Crisis

Following Jeske's (2006) decentralized international risk sharing arrangement where residents have access to international capital markets, this paper studies the presence of resident default risk on borrowing happened between domestic agents, in addition to default risk on private debt contracts across border. The paper shows that, without the assumption of perfect domestic contract enforcement, more international risk sharing and higher welfare can be supported. Moreover, the domestic interest rate equals to the highest marginal rate of substitution in countries that are participation constrained in international financial markets. This asset pricing result overturns the well established argument that interest rate should be the lowest to induce repayment in closed economy models with domestic credit crisis.

https://mpra.ub.uni-muenchen.de/17126/1/MPRA_paper_17126.pdf

Private Debt with Default Risk within and across Border

I study a model of investment by financially constrained firms that are heterogeneous with respect to their exposure to an aggregate liquidity shock. A firm that is susceptible to the shock will mitigate its exposure by purchasing claims issued by a firm that is not. Liabilities of an unaffected firm may earn a liquidity premium due to their fungibility; and, because they are backed by productive investment, their supply is elastic to the demand. This segmentation implies that an aggregate liquidity shock has different consequences across sectors of the economy.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1424445_code673981.pdf?abstractid=930411&mirid=5

The Elastic Provision of Liquidity by Private Agents

I study efficient risk-sharing in an endowments economy when enforcement is achieved by the threat of reversion to punishments that may be less severe than autarkic consumption. I characterize (up to a technical condition) the set of allocations that may be interpreted as efficient with respect to some punishment convention. The conditions rationalizing such efficiency are very weak; they are (i) resource exhaustion, (ii) satisfaction of individual rationality constraints at each continuation, and (iii) finiteness of the value of the allocation under the implicit decentralizing price system. I show how efficient allocations may be decentralized, and I state versions of the Welfare Theorems for these economies.

Sharing Risk Efficiently under Suboptimal Punishments for Defection

I study a DSGE model incorporating a monetary transactions technology in which a representative household invests time to improve its skill (human capital) in making transactions. The model is designed to reconcile salient short- and long-run features of the relationship between money, income, and the opportunity cost of holding money. An econometric reduced form, derived analytically, is revealing for the nature of pathologies perceived by the empirical money demand literature; particularly interesting is the possibility of a moving average root close to the unit circle. The impact elasticity of the M1-income ratio to an innovation to the opportunity cost is about 0:1, whereas the long-run response to a unit permanent shift is 1. In comparison to less parsimonious models, parametric restrictions are not rejected, and outof-sample forecasts are improved. The theory also yields implications for the – –

A Theory of Financial Innovation and Monetary Substitution with an Application to a Century of Data on the M1-Income Ratio (Preliminary)

I study the efficient risk-sharing in an endowments economy when enforcement is achieved by the threat of reversion to punishments that may be less severe than autarkic consumption. I characterize (up to a technical condition) the set of allocations that may be interpreted as efficient with respect to some punishment convention. The conditions rationalizing such efficiency are very weak; they are (i) resource exhaustion, (ii) satisfaction of individual rationality constraints at each continuation, and (iii) finiteness of the value of the allocation under the implicit decentralizing price system. I show how efficient allocations may be decentralized, and I state versions of the Welfare Theorems for these economies.

Sharing Risk Efficiently Under Suboptimal Punishments for Defection

I study a model of investment by financially constrained firms that are heterogeneous with respect to their exposure to an aggregate liquidity shock. A firm that is susceptible to the shock will mitigate its exposure by purchasing claims issued by a firm that is not. Liabilities of an unaffected firm may earn a liquidity premium due to their fungibility, and because they are backed by productive investment, their supply is elastic to the demand. This segmentation implies that an aggregate liquidity shock has different consequences across sectors of the economy.

Drew Saunders

Papers

The Elastic Provision of Liquidity by Private Agents

Sharing Risk Efficiently under Suboptimal Punishments for Defection

A Theory of Financial Innovation and Monetary Substitution with an Application to a Century of Data on the M1-Income Ratio (Preliminary)

Sharing Risk Efficiently Under Suboptimal Punishments for Defection

The Elastic Provision of Liquidity by Private Agents