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Asset Prices and asset Correlations in Illiquid Markets

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Author Info
Celso Brunetti () (Finance Johns Hopkins University)
Alessio Caldarera (BPN Paribas)

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Abstract

We build a new asset pricing framework to study the effects of aggregate illiquidity on asset prices, volatilities and correlations. In our framework the Black-Scholes economy is obtained as the limiting case of perfectly liquid markets. The model is consistent with empirical studies on the effects of illiquidity on asset returns, volatilities and correlations. We present the model, study its qualitative properties and estimate stocks' sensitivities to aggregate liquidity ($\beta$s) using nine years data for 24 randomly sampled stocks traded on the NYSE. These sensitivity parameters ($\beta$s) determine the effect that aggregate illiquidity has on expected returns, volatilities, correlations, CAPM-betas and Sharpe ratios. We find clear capitalization and sector patterns for liquidity $\beta$s.

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2006 with number 331.

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Date of creation: 04 Jul 2006
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Handle: RePEc:sce:scecfa:331

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Keywords: Market Liquidity Volatilities Correlations Asset Pricing GMM

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G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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  1. Chordia, Tarun & Roll, Richard & Subrahmanyam, Avanidhar, 2000. "Commonality in liquidity," Journal of Financial Economics, Elsevier, vol. 56(1), pages 3-28, April. [Downloadable!] (restricted)
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  3. Chan, K C, et al, 1992. " An Empirical Comparison of Alternative Models of the Short-Term Interest Rate," Journal of Finance, American Finance Association, vol. 47(3), pages 1209-27, July. [Downloadable!] (restricted)
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  6. Andrew Ang & Robert J. Hodrick & Yuhang Xing & Xiaoyan Zhang, 2004. "The Cross-Section of Volatility and Expected Returns," NBER Working Papers 10852, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  7. Gourieroux, C & Monfort, A & Renault, E, 1993. "Indirect Inference," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 8(S), pages S85-118, Suppl. De. [Downloadable!] (restricted)
    Other versions:
    • Gourieroux, C. & Monfort, A. & Renault, E., 1992. "Indirect Inference," Papers 92.279, Toulouse - GREMAQ.
    • Gourieroux, C. & Monfort, A & Renault, E., 1992. "Indirect Inference," Papers 9215, Institut National de la Statistique et des Etudes Economiques-.
  8. Pástor, Lubos & Stambaugh, Robert F, 2002. "Liquidity Risk and Expected Stock Returns," CEPR Discussion Papers 3494, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  9. Tarun Chordia, 2001. "Market Liquidity and Trading Activity," Journal of Finance, American Finance Association, vol. 56(2), pages 501-530, 04. [Downloadable!] (restricted)
  10. Dietrich-Campbell, Bruce & Schwartz, Eduardo, 1986. "Valuing debt options : Empirical evidence," Journal of Financial Economics, Elsevier, vol. 16(3), pages 321-343, July. [Downloadable!] (restricted)
  11. Amihud, Yakov, 2002. "Illiquidity and stock returns: cross-section and time-series effects," Journal of Financial Markets, Elsevier, vol. 5(1), pages 31-56, January. [Downloadable!] (restricted)
  12. Francis A. Longstaff, 2004. "Financial Claustrophobia: Asset Pricing in Illiquid Markets," NBER Working Papers 10411, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  13. K. Ronnie Sircar, George Papanicolaou, 1998. "General Black-Scholes models accounting for increased market volatility from hedging strategies," Applied Mathematical Finance, Taylor and Francis Journals, vol. 5(1), pages 45-82, March. [Downloadable!] (restricted)
  14. Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, vol. 50(1), pages 53-85, March. [Downloadable!] (restricted)
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