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Liquidity might come at cost: The role of heterogeneous preferences

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  • Hauser, Shmuel
  • Kedar-Levy, Haim

Abstract

Asset-pricing models with volume are challenged by the high turnover-rates in real stock markets. We develop an asset-pricing framework with heterogeneous risk preferences and show that liquidity and turnover increase with heterogeneity to a maximum, and then decline. With U.S. parameters, turnover exceeds 55%. Liquidity is costly since it facilitates a large share redistribution across agents, causing changes in average risk aversion, which increases Sharpe ratio variability, and hence stock return volatility. Illiquidity and its risk are minimized at moderate heterogeneity levels, highlighting an "optimal" heterogeneity level, yet, there is no "optimal" combination between liquidity level and Sharpe ratio variability.

Suggested Citation

  • Hauser, Shmuel & Kedar-Levy, Haim, 2018. "Liquidity might come at cost: The role of heterogeneous preferences," Journal of Financial Markets, Elsevier, vol. 39(C), pages 1-23.
    • Handle: RePEc:eee:finmar:v:39:y:2018:i:c:p:1-23
    DOI: 10.1016/j.finmar.2018.03.001
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    Cited by:

    1. Elroi Hadad & Haim Kedar-Levy, 2022. "The Impact of Retail Investors Sentiment on Conditional Volatility of Stocks and Bonds," Papers 2208.01538, arXiv.org.
    2. Kedar-Levy, Haim, 2020. "Price discovery in the small and in the large: Momentum and reversal, bubbles, and crashes," Journal of Financial Markets, Elsevier, vol. 48(C).
    3. Kedar-Levy, Haim & Kim, Joon-Seok & Yoo, Sean Sehyun, 2025. "Predictable liquidity properties in a Segmented, inelastic stock market," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 103(C).
    4. Hadad, Elroi & Kedar-Levy, Haim, 2024. "The impact of retail investor sentiment on the conditional volatility of stocks and bonds: Evidence from the Tel-Aviv stock exchange," International Review of Economics & Finance, Elsevier, vol. 89(PA), pages 1303-1313.

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    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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