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Asset Prices and asset Correlations in Illiquid Markets

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  • Celso Brunetti

    ()
    (Finance Johns Hopkins University)

  • Alessio Caldarera

    (BPN Paribas)

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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Bibliographic Info

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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Cited by:
  1. Marsili, Matteo & Raffaelli, Giacomo & Ponsot, Benedicte, 2009. "Dynamic instability in generic model of multi-assets markets," Journal of Economic Dynamics and Control, Elsevier, vol. 33(5), pages 1170-1181, May.
  2. Feng, Shih-Ping & Hung, Mao-Wei & Wang, Yaw-Huei, 2014. "Option pricing with stochastic liquidity risk: Theory and evidence," Journal of Financial Markets, Elsevier, vol. 18(C), pages 77-95.

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