Asset Pricing with Liquidity Risk
by Viral V. Acharya of the London Business School, and
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 liquidity-adjusted 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 cross-sectional tests is consistent with liquidity risk being priced.
Published in: Journal of Financial Economics, Vol. 77, No. 2, (August 2005), pp. 375-410.