Asset Pricing with Liquidity Risk

ASSET PRICING WITH LIQUIDITY RISK Viral V. Acharya Lasse Heje Pedersen Working Paper 10814 http://www.nber.org/papers/w10814 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 September 2004

We are grateful for conversations with Andrew Ang, Joseph Chen, Sergei Davydenko, Francisco Gomes, Joel Hasbrouck, Andrew Jackson, Tim Johnson, Martin Lettau, Anthony Lynch, Stefan Nagel, Lubos Pastor, Tano Santos, Dimitri Vayanos, Luis Viceira, Jeff Wurgler, and seminar participants at London Business School, London School of Economics, New York University, the National Bureau of Economic Research (NBER) Summer Institute 2002, the Five Star Conference 2002,Western Finance Association Meetings 2003, and the Texas Finance Festival 2004. We are especially indebted to Yakov Amihud and to an anonymous referee for help and many valuable suggestions. All errors remain our own. The views expressed herein are those of the author(s) and not necessarily those of the National Bureau of Economic Research. ©2004 by Viral V. Acharya and Lasse Heje Pedersen. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

Asset Pricing with Liquidity Risk Viral V. Acharya and Lasse Heje Pedersen NBER Working Paper No. 10814 September 2004 JEL No. G0, G1, G12

ABSTRACT This paper solves explicitly an equilibrium asset pricing model with liquidity risk – the risk arising from unpredictable changes in liquidity over time. In our liquidity-adjusted capital asset pricing model, a security's required return depends on its expected liquidity as well as on the covariances of its own return and liquidity with market return and market liquidity. In addition, the model shows how a negative shock to a security's liquidity, if it is persistent, results in low contemporaneous returns and high predicted future returns. The model provides a...