Asset pricing with liquidity risk

Acharya, V and Pedersen, L H (2003) Asset pricing with liquidity risk. Working Paper. London Business School IFA Working Paper.

Abstract

This paper studies equilibrium asset pricing with liquidity risk the risk arising from unpredictable changes in liquidity over time. It is shown that a security's required return depends on its expected illiquidity and on the covariances of its own return and illiquidity with market return and market illiquidity. This gives rise to a liquidityadjusted capital asset pricing model. Further, if a security's liquidity is persistent, a shock to its illiquidity results in low contemporaneous returns and high predicted future returns. Empirical evidence based on crosssectional tests is consistent with liquidity risk being priced.