Liquidity and Asset Prices

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.

Market Power in the Portfolio: Product Market Competition and Mutual Fund Performance

“…Consistent with monopoly stocks providing stability with secure cash flows and less product market threats, funds with a higher MB have a lower portfolio turnover and hold stocks over a longer period. Moreover, the lower trading frequency should allow the fund manager to invest into more illiquid securities to earn a liquidity premium (e.g., Amihud, Mendelson, and Pedersen (2005)), which is also supported by the results. Finally, their potential profitability makes monopoly firms suitable instruments to pursue quality investing.…”

Role of Liquidity in Explaining Anomalous Returns: Evidence from Emerging Market

“…Stocks which are hard to exchange are considered as illiquid stocks and stocks which are easily exchangeable are called liquid stocks (Bali, Engle, & Murray, 2016). However, liquidity is a complex phenomenon which is unobservable in the market place (Amihud, Mendelson, & Pedersen, 2005). Standard asset pricing models such as CAPM and Arbitrage Pricing Theory (APT) of Ross (1976), it is assumed that markets are liquid (frictionless).…”

“…It asserts that there are no costs involved in buying and selling Mohsin Sadaqat , Hilal Anwar Butt 5 of securities. However, existence of trade impediments cause liquidity constraints in the market place, which derive the securities prices away from its intrinsic values (Amihud, Mendelson, & Pedersen, 2005). Numerous researchers study the role of liquidity in deriving the expected returns of financial instruments.…”

Efficient hedge fund style allocations: A rules-based model

“…6. For a survey of recent literature on liquidity and asset pricing, see Amihud et al (2005). As we allocate across different hedge fund styles, our analysis is restricted to market illiquidity.…”