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Flight to Quality, Flight to Liquidity, and the Pricing of Risk

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  • Dimitri Vayanos

Abstract

We propose a dynamic equilibrium model of a multi-asset market with stochastic volatility and transaction costs. Our key assumption is that investors are fund managers, subject to withdrawals when fund performance falls below a threshold. This generates a preference for liquidity that is time-varying and increasing with volatility. We show that during volatile times, assets' liquidity premia increase, investors become more risk averse, assets become more negatively correlated with volatility, assets' pairwise correlations can increase, and illiquid assets' market betas increase. Moreover, an unconditional CAPM can understate the risk of illiquid assets because these assets become riskier when investors are the most risk averse.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10327.

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Date of creation: Feb 2004
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Handle: RePEc:nbr:nberwo:10327

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