Asset pricing with downside liquidity risks

Publication Type:
Journal Article
Citation:
Management Science, 2017, 63 (8), pp. 2549 - 2572
Issue Date:
2017-08-01
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© 2016 INFORMS. We develop a parsimonious liquidity-adjusted downside capital asset pricing model to investigate whether phenomena such as downward liquidity spirals and flights to liquidity impact expected asset returns.We find strong empirical support for the model. Downside liquidity risk (sensitivity of stock liquidity to negative market returns) has an economically meaningful return premium that is 10 times larger than its symmetric analogue. The expected liquidity level and downside market risk are also associated with meaningful return premiums. Downside liquidity risk and its associated premium are higher during periods of low marketwide liquidity and for stocks that are relatively small, illiquid, volatile, and have high book-to-market ratios. These results are consistent with investors requiring compensation for holding assets susceptible to adverse liquidity phenomena. Our findings suggest that mitigation of downside liquidity risk can lower firms' cost of capital.
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