Asset Pricing and Market Liquidity

Traditional asset pricing models are based on the notion that aggregate market risks rather than individual risks are priced in a market that has reached an equilibrium between supply and demand from participants. The assets prices under this paradigm generally agree with the fundamental value of the asset, and all you need for asset pricing is knowledge of the cash flows or payoff and a specification of the discount factor. This traditional economic paradigm, discussed in chapter 1, further assumes that markets are frictionless, or perfectly liquid, and that capital is freely available. Yet this traditional paradigm has limited ability to explain empirically observed market behaviour because it either dismisses the issue of market liquidity as a friction or accounts for market liquidity by adding a transaction cost to the fundamental value. Market liquidity is typically incorporated as an exogenous transaction cost—an afterthought to asset pricing. The simplicity of this view is appealing, and for the ignorant market participant it may be sufficient. It acknowledges the difference between the transaction price and the fundamental value of an asset, and further attributes this difference to the costs of trading. Incidentally, adding trading costs violates the basic assumption of frictionless markets on which most classical asset pricing models are based.