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Asset Pricing in Markets with Illiquid Assets


  • Longstaff, Francis A


Many important classes of assets are illiquid in the sense that they cannot always be traded immediately. Thus, a portfolio position in these types of illiquid investments becomes at least temporarily irreversible. We study the asset-pricing implications of illiquidity in a two-asset exchange economy with heterogeneous agents. In this market, one asset is always liquid. The other asset can be traded initially, but then not again until after a “blackout†period. Illiquidity has a dramatic effect on optimal portfolio decisions. Agents abandon diversification as a strategy and choose highly polarized portfolios instead. The value of liquidity can represent a large portion of the equilibrium price of an asset. We present examples in which a liquid asset can be worth up to 25 percent more than an illiquid asset even though both have identical cash flow dynamics. We also show that the expected return and volatility of an asset can change significantly as the asset becomes relatively more liquid.

Suggested Citation

  • Longstaff, Francis A, 2005. "Asset Pricing in Markets with Illiquid Assets," University of California at Los Angeles, Anderson Graduate School of Management qt2458g38x, Anderson Graduate School of Management, UCLA.
  • Handle: RePEc:cdl:anderf:qt2458g38x

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    References listed on IDEAS

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    Cited by:

    1. Huyên Pham & Peter Tankov, 2008. "A Model Of Optimal Consumption Under Liquidity Risk With Random Trading Times," Mathematical Finance, Wiley Blackwell, vol. 18(4), pages 613-627.
    2. repec:rss:jnljef:v5i1p2 is not listed on IDEAS
    3. Kamara, Avraham & Lou, Xiaoxia & Sadka, Ronnie, 2008. "The divergence of liquidity commonality in the cross-section of stocks," Journal of Financial Economics, Elsevier, vol. 89(3), pages 444-466, September.
    4. Gupta, Anurag & Singh, Ajai K. & Zebedee, Allan A., 2008. "Liquidity in the pricing of syndicated loans," Journal of Financial Markets, Elsevier, vol. 11(4), pages 339-376, November.
    5. repec:bbz:fcpbbr:v:11:y:2014:i:1:p:69-89 is not listed on IDEAS
    6. Boyle, Glenn & Evans, Lewis & Guthrie, Graeme, 2006. "Estimating the WACC in a Regulatory Setting: An Assessment of Dr Martin Lally's paper 'The Weighted Average Cost of Capital for Electricity Lines Businesses' of 8 September 2005," Working Paper Series 3844, Victoria University of Wellington, The New Zealand Institute for the Study of Competition and Regulation.

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