Liquidity Shocks and Equilibrium Liquidity Premia
by Ming Huang of Stanford University
Abstract: This paper studies the impact of transactions costs on portfolio policy and equilibrium asset returns. In our economy agents face surprise liquidity shocks and can invest in liquid and illiquid riskless assets. For agents who face a random holding horizon due to liquidity shocks, the return of the illiquid security is risky. Although such risk is not significantly priced when investors can borrow against future income, agents who are constrained from borrowing against their future income stream demand a large premium for bearing such risk. The equilibrium liquidity premium can be much higher than that demanded by investors with a fixed investment horizon that is equal to the expected arrival time of a liquidity shock. Our result can be helpful in understanding why some securities have high liquidity premia, despite their relatively low turnover frequency.
Keywords: Liquidity shocks, Liquidity premium.
Published in: Journal of Economic Theory, Vol. 109, No. 1, (March 2003), pp. 104-129.