Liquidity Risk on Asset Pricing

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Investors require compensation for the trading costs they pay when they buy or sell securities. If two assets generate the same cash flows over time but one of them is less liquid has higher trading costsrational investors will pay less for the less liquid asset, which costs more to trade.

Consequently, the less-liquid asset will have a lower value and a higher required expected return. Overall, we should observe that the returns on financial assets are increasing in asset illiquidity or transaction costs. Just as risk-averse investors require a higher return to compensate for a higher asset risk, we propose that investors require a higher return to compensate for greater asset illiquidity or transaction costs.

Illiquidity means incurring high transaction cost, which includes a large price impact when market liquidity asset pricing risk and crisis in ukraine and facing a long time to unload a large position. Liquidity risk is higher if a security becomes more illiquid when it needs to be traded in the future, which will raise its trading cost. The analysis in this book shows that higher illiquidity and greater liquidity risk reduce securities prices and raise the expected return that investors require as compensation.

Aggregate market liquidity is linked to funding liquidity, which affects the provision of liquidity services. When these become constrained, there is a liquidity crisis, which leads to downward price and liquidity spiral. Overall, this book demonstrates the important role of market liquidity asset pricing risk and crisis in ukraine in asset pricing.

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You are about to leave AQR. Asset Pricing, Risk and Crises. Cambridge University Press Investors require compensation for the trading costs they pay when they buy or sell securities.

Market liquidity asset pricing risk and crisis in ukraine and Pricing Liquidity Risk. Liquidity and Asset Prices. Liquidity and Risk Management. Market Liquidity and Funding Liquidity. You are now leaving AQR.

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This is an open-access article distributed under the terms of the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original author and source are credited.

Financial theory suggests that expected asset returns are related to systematic risk associated with common factors.

In equilibrium, an asset whose returns are more sensitive to risk factors should offer higher returns to compensate investors for holding the asset. The literature has presented several stock market and term structure factors important for the cross section of asset returns. Recent studies have further suggested liquidity as another good candidate for a priced state variable. Liquidity is often viewed as an important feature of the investment environment. All else equal, investors should require higher returns on assets whose returns have greater sensitivities to marketwide liquidity.

Pastor [ 1 ] investigate whether marketwide liquidity is a state variable important for pricing stocks. They find that expected stock returns are positively related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Acharya [ 2 ] develop a liquidity-adjusted Capital Asset Pricing Model CAPM under timevarying liquidity and demonstrate that the required return of an asset depends on expected liquidity and covariances of its returns and liquidity with market returns and liquidity.

Empirical evidence shows that liquidity risk is important beyond the effects of market risk and the level of liquidity in the equity market. The corporate bond market is much less liquid than the equity market with most corporate bonds trading infrequently. Thus, the level of liquidity is a serious concern for participants in the corporate bond market. Understanding how corporate bonds are priced is essential for developing a unified theory of asset pricing.

How financial markets price corporate bonds and what are the key determinants of required returns are issues of fundamental importance to academics and practitioners. For academics, exploring the role of liquidity risk in corporate bond pricing is a necessary step toward understanding the determinants of the cost of borrowing. Lin [ 3 ] used both regression and portfolio-based test methodologies to examine whether liquidity risk explains cross-sectional variations in expected corporate bond returns.

Empirical evidence from both analyses strongly suggests that the liquidity risk factor is priced in corporate bond returns. There are significant monotonic variations in returns of beta-sorted portfolios related to liquidity risk, which are independent of the effects of default and term betas and ratings.

A significant positive relation exists between expected corporate bond returns and liquidity beta in the cross-sectional regression. More important, there is a strong positive relation between liquidity risk and expected corporate bond returns even after controlling for the effects of other risk factors, expected liquidity, and bond characteristics.

This positive relation is robust to different empirical specifications of corporate bond pricing models and choices of a variety of proxies for the liquidity factor. Liquidity risk spread accounts for a significant portion of corporate bond risk premium. Results strongly suggest that liquidity risk is an important determinant of expected corporate bond returns. Please leave a message, we will get back you shortly. Home Publications Conferences Register Contact.

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