LAPM: A Liquidity-Based Asset Pricing Model

TLDR: In this paper, the authors develop an alternative approach to asset pricing based on corporations' desire to hoard liquidity. But their approach is limited to the case of financial assets and does not consider consumer's time preference and risk aversion in determining asset prices.

Abstract: The intertemporal CAPM predicts that an asset's price is equal to the expectation of the product of the asset's payoff and a representative consumer's intertemporal marginal rate of substitution. This paper develops an alternative approach to asset pricing based on corporations' desire to hoard liquidity. Our corporate finance approach suggests new determinants of asset prices such as the distribution of wealth within the corporate sector and between the corporate sector and the consumers. Also, leverage ratios, capital adequacy requirements, and the composition of savings affect the corporate demand for liquid assets and, thereby, interest rates. STARTING WITH THE CAPITAL ASSET PRICING MODEL (CAPM, derived by Sharpe (1964), Lintner (1965), and Mossin (1966)), market finance has emphasized the role of consumers' time preference and risk aversion in determining asset prices. The intertemporal consumption-based asset pricing model (e.g., Rubinstein (1976), Lucas (1978), Breeden (1979), Harrison and Kreps (1979), Cox, Ingersoll, and Ross (1985), Hansen and Jagannathan (1991)) predicts that an asset's current price is equal to the expectation, conditioned on current information, of the product of the asset's payoff and a representative consumer's intertemporal marginal rate of substitution (IMRS). While fundamental, this dominant paradigm for pricing assets has some wellrecognized shortcomings (see below), and there is clearly scope for alternative and complementary approaches. This paper begins developing one such approach based on aggregate liquidity considerations.1 Our starting point is that the productive and financial spheres of the economy have autonomous demands for financial assets and that their valuations for these assets are often disconnected from the representative consumer's. Corporate demand for financial assets is driven by the desire to hoard liquidity in order to fulfill future cash needs. In contrast with the