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Asset market equilibrium with liquidity risk

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  • Robert Jarrow

    (Cornell University
    Kamakura Corporation)

Abstract

This paper derives an equilibrium asset pricing model with endogenous liquidity risk. Liquidity risk is modeled as a stochastic quantity impact on the price from trading, where the size of the impact depends on trade size. Under a strong set of assumptions, we prove that a unique equilibrium liquidity cost process and a unique equilibrium price process exists for our economy. We characterize the market’s state price density, which enables the derivation of the risk-return relation for the stock’s expected return including liquidity risk. We derive a generalized intertemporal CAPM and consumption CAPM for these markets. In contrast to the traditional models without liquidity risk, there is an additional systematic liquidity risk factor which is related to the stock return’s covariation with the market’s stochastic liquidity cost. Traditional transaction costs are a special case of our formulation.

Suggested Citation

  • Robert Jarrow, 2018. "Asset market equilibrium with liquidity risk," Annals of Finance, Springer, vol. 14(2), pages 253-288, May.
    • Handle: RePEc:kap:annfin:v:14:y:2018:i:2:d:10.1007_s10436-017-0316-x
    DOI: 10.1007/s10436-017-0316-x
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    References listed on IDEAS

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    Cited by:

    1. Jarrow, Robert & Li, Siguang, 2021. "Endogenous liquidity risk and dealer market structure," The Quarterly Review of Economics and Finance, Elsevier, vol. 81(C), pages 449-453.

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    More about this item

    Keywords

    Liquidity risk; Asset market equilibrium; Systematic risk; Intertemporal CAPM; Consumption CAPM;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets

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