Liquidity and Asset Prices

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Abstract

We review the theories on how liquidity affects the required returns of\ncapital assets and the empirical studies that test these theories. The\ntheory predicts that both the level of liquidity and liquidity risk are\npriced, and empirical studies find the effects of liquidity on asset prices\nto be statistically significant and economically important, controlling\nfor traditional risk measures and asset characteristics. Liquidity-based\nasset pricing empirically helps explain (1) the cross-section of stock\nreturns, (2) how a reduction in stock liquidity result in a reduction in\nstock prices and an increase in expected stock returns, (3) the yield differential\nbetween on- and off-the-run Treasuries, (4) the yield spreads\non corporate bonds, (5) the returns on hedge funds, (6) the valuation of\nclosed-end funds, and (7) the low price of certain hard-to-trade securities\nrelative to more liquid counterparts with identical cash flows, such\nas restricted stocks or illiquid derivatives. Liquidity can thus play a role\nin resolving a number of asset pricing puzzles such as the small-firm\neffect, the equity premium puzzle, and the risk-free rate puzzle.

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