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Liquidity premium in the presence of stock market crises and background risk

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  • Sergey Isaenko
  • Rui Zhong

Abstract

We analyse a portfolio optimization problem for a long-term investor in the presence of stock market crises. A crisis includes a crash of the stock market price, a sharp increase of its volatility and dramatic deterioration of liquidity. We model the stock market illiquidity by means of convex transaction costs that mimic the presence of an effective bid-ask spread that increases with the size of a trade. We find that the existence of stock market crises results in a significant liquidity premium. Furthermore, the presence of background risk has a negative impact on the liquidity premium.

Suggested Citation

  • Sergey Isaenko & Rui Zhong, 2015. "Liquidity premium in the presence of stock market crises and background risk," Quantitative Finance, Taylor & Francis Journals, vol. 15(1), pages 79-90, January.
    • Handle: RePEc:taf:quantf:v:15:y:2015:i:1:p:79-90
    DOI: 10.1080/14697688.2013.856517
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