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Liquidity and Asset Prices

01 Jan 2005-Research Papers in Economics (University Library of Munich, Germany)-
TL;DR: In this paper, the authors review the theories on how liquidity affects the required returns of capital assets and the empirical studies that test these theories and find the effects of liquidity on asset prices to be statistically significant and economically important, controlling for traditional risk measures and asset characteristics.
Abstract: 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.
Citations
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Book ChapterDOI
01 Jan 2012
TL;DR: In this paper, a simple equilibrium model with liquidity risk is proposed, where a security's required return depends on its expected liquidity as well as on the covariances of its own return and liquidity with the market return.
Abstract: This paper solves explicitly a simple equilibrium model with liquidity risk. In our liquidityadjusted 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 the market return and liquidity. In addition, a persistent negative shock to a security s liquidity results in low contemporaneous returns and high predicted future returns. The model provides a 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 and provide evidence of flight to liquidity. r 2005 Elsevier B.V. All rights reserved.

1,156 citations

Posted Content
TL;DR: In this article, a self-reinforcing positive relationship between price informativeness and liquidity is shown to be a source of fragility, and a small drop in the liquidity of one asset can, through a feedback loop, result in a very large drop in market liquidity and prices of other assets.
Abstract: Liquidity providers often learn information about an asset from prices of other assets. We show that this generates a self-reinforcing positive relationship between price informativeness and liquidity. This relationship causes liquidity spillovers and is a source of fragility: a small drop in the liquidity of one asset can, through a feedback loop, result in a very large drop in market liquidity and price informativeness (a liquidity crash). This feedback loop provides a new explanation for comovements in liquidity and liquidity dry-ups. It also generates multiple equilibria.

146 citations

13 Dec 2018
TL;DR: In this paper, the authors present three essays, included as separate chapters, that each focus on a separate question related to raising capital via primary markets, including the market for initial public stock offerings.
Abstract: markdownThis thesis aims to foster a greater understanding of primary market functioning. It aims to be of use as an input in the continuous debate on how we can best shape our financial markets to provide greater affluence for society. It contains three essays, included as separate chapters, that each focus on a separate question related to raising capital via primary markets. Chapter 2 deals with the market for initial public stock offerings. It shows that stereotypes about industry performance are related to the opening performance of newly issued stocks. Chapter 3 deals with the general market for new equity. It shows that firms issue more new stocks when markets become more liquid; i.e., when it becomes easier to buy or sell large quantities of stocks without having to make adjustments in the price. Chapter 4 deals with the market for new hybrid capital. It shows that banks make riskier decisions after issuing Contingent Convertible bonds.

36 citations

Posted Content
TL;DR: In this paper, trading fees are incorporated in a long-horizon dynamic general-equilibrium model in which traders optimally and endogenously decide when and how much to trade.
Abstract: We incorporate trading fees in a long-horizon dynamic general-equilibrium model in which traders optimally and endogenously decide when and how much to trade. A full characterization of equilibrium is provided, which allows us to study the dynamics of equilibrium trades, equilibrium asset prices and rates of return in the presence of trading fees. We exhibit the effect of trading fees on deviations from the consumption- CAPM and analyze the pricing of endogenous liquidity risk. We compare, for the same shocks, the impulse responses of this model to those of a model in which trading is infrequent because of trader inattention. The current version reflects material that was previously in two papers, w21421 and w19155.

32 citations

Posted Content
Yakov Amihud1
TL;DR: In this paper, a return factor of illiquid-minus-liquid stocks, called IML, is presented, which provides a time series of the illiquidity premium of stocks.
Abstract: This paper explains and extends my 2002 paper. It presents a return factor of illiquid-minus-liquid stocks, called IML, which provides a time series of the illiquidity premium. The risk-adjusted predicted return on IML is lower in the period that follows my 2002 paper but it is still significant. IML also has the predicted response to market illiquidity shocks.

31 citations

References
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Journal ArticleDOI
TL;DR: In this article, the authors identify five common risk factors in the returns on stocks and bonds, including three stock-market factors: an overall market factor and factors related to firm size and book-to-market equity.

24,874 citations

Journal ArticleDOI
TL;DR: In this article, the relationship between average return and risk for New York Stock Exchange common stocks was tested using a two-parameter portfolio model and models of market equilibrium derived from the two parameter portfolio model.
Abstract: This paper tests the relationship between average return and risk for New York Stock Exchange common stocks. The theoretical basis of the tests is the "two-parameter" portfolio model and models of market equilibrium derived from the two-parameter portfolio model. We cannot reject the hypothesis of these models that the pricing of common stocks reflects the attempts of risk-averse investors to hold portfolios that are "efficient" in terms of expected value and dispersion of return. Moreover, the observed "fair game" properties of the coefficients and residuals of the risk-return regressions are consistent with an "efficient capital market"--that is, a market where prices of securities

14,171 citations

Book ChapterDOI
TL;DR: In this article, the problem of selecting optimal security portfolios by risk-averse investors who have the alternative of investing in risk-free securities with a positive return or borrowing at the same rate of interest and who can sell short if they wish is discussed.
Abstract: Publisher Summary This chapter discusses the problem of selecting optimal security portfolios by risk-averse investors who have the alternative of investing in risk-free securities with a positive return or borrowing at the same rate of interest and who can sell short if they wish. It presents alternative and more transparent proofs under these more general market conditions for Tobin's important separation theorem that “ … the proportionate composition of the non-cash assets is independent of their aggregate share of the investment balance … and for risk avertere in purely competitive markets when utility functions are quadratic or rates of return are multivariate normal. The chapter focuses on the set of risk assets held in risk averters' portfolios. It discusses various significant equilibrium properties within the risk asset portfolio. The chapter considers a few implications of the results for the normative aspects of the capital budgeting decisions of a company whose stock is traded in the market. It explores the complications introduced by institutional limits on amounts that either individuals or corporations may borrow at given rates, by rising costs of borrowed funds, and certain other real world complications.

9,970 citations

Journal ArticleDOI

9,341 citations

Journal ArticleDOI
TL;DR: Scholes et al. as discussed by the authors examined the relationship between the total market value of the common stock of a firm and its return and found that small firms had higher risk adjusted returns than large firms.

5,997 citations