Liquidity, Equity Premium and Participation (original) (raw)
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The liquidity component of the equity premium
papers.ssrn.com
Adding a motivation for trading due to endowment differences to standard asset pricing assumptions, we investigate the impact of illiquidity due to small numbers of participants. We calibrate to observed activity levels, returns, transaction costs and volatility in equity markets. We show that, while the price of an illiquid asset is itself unaffected by its illiquidity, with the introduction of an equivalent liquid asset, which trades at a premium, we nonetheless replicate the findings of . The required transactional charges are modest in some calibrations. We show that the major part of the equity premium can be explained as a liquidity premium.
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We examine how liquidity and asset prices are affected by the following market imperfections: asymmetric information, participation costs, transaction costs, leverage constraints, non-competitive behavior and search. Our model has three periods: agents are identical in the first, become heterogeneous and trade in the second, and consume asset payoffs in the third.
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In financial markets characterized by imperfect depth, speculative trading will have tran-sitory effects on the market price as market makers must be compensated for the risk of holding the asset. The number of people providing liquidity to a market will generally be ...
We survey the theoretical literature on market liquidity. The literature traces illiquidity, i.e., the lack of liquidity, to underlying market imperfections. We consider six main imperfections: participation costs, transaction costs, asymmetric information, imperfect competition, funding constraints, and search. We address three questions in the context of each imperfection: (a) how to measure illiquidity, (b) how illiquidity relates to underlying market imperfections and other asset characteristics, and (c) how illiquidity affects expected asset returns. We nest all six imperfections within a common, unified model, and use that model to organize the literature.
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Acknowledgments: The authors are pleased to acknowledge the very helpful comments of two anonymous referees and the expert assistance of Frida Lie and Ali Suleyman. Abstract: In this paper, we examine the asset pricing role of liquidity (as proxied by share turnover) in the context of the Fama and French three-factor model. Our analysis employs monthly Australian data, covering the sample period 1990 to 1998. The key finding of our research is that the GMM test is unable to reject the test of over-identifying restrictions -thus supporting the overall favourability of the liquidity augmented Fama-French model.
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Role of Liquidity in Asset Pricing
Relationship between liquidity and asset prices has attracted considerable attention since . A number of proxies have been used to measure liquidity but a direct objective measure is lacking. This paper introduces a directly observable measure of liquidity and compares its performance to the widely used bid ask spread measure of liquidity introduced by Amihud and Mendelson's (1986) seminal work. The results indicate that this measure of liquidity substantially outperforms the traditional measure and may be useful in predicting market level price changes.
Liquidity might come at cost: The role of heterogeneous preferences
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Asset-pricing models with volume are challenged by the high turnover-rates in real stock markets. We develop an asset-pricing framework with heterogeneous risk preferences and show that liquidity and turnover increase with heterogeneity to a maximum, and then decline. With U.S. parameters, turnover exceeds 55%. Liquidity is costly since it facilitates a large share redistribution across agents, causing changes in average risk aversion, which increases Sharpe ratio variability, and hence stock return volatility. Illiquidity and its risk are minimized at moderate heterogeneity levels, highlighting an "optimal" heterogeneity level, yet, there is no "optimal" combination between liquidity level and Sharpe ratio variability.