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Flight to quality, flight to liquidity, and the pricing of risk

  • Dimitri Vayanos

We propose a dynamic equilibrium model of a multi-asset market with stochastic volatility and transaction costs. Our key assumption is that investors are fund managers, subject to withdrawals when fund performance falls below a threshold. This generates a preference for liquidity that is time-varying and increasing with volatility. We show that during volatile times, assets' liquidity premia increase, investors become more risk averse, assets become more negatively correlated with volatility, assets' pairwise correlations can increase, and illiquid assets' market betas increase. Moreover, an unconditional CAPM can understate the risk of illiquid assets because these assets become riskier when investors are the most risk averse.

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File URL: http://eprints.lse.ac.uk/456/
File Function: Open access version.
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Paper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 456.

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Length: 54 pages
Date of creation: Feb 2004
Date of revision:
Handle: RePEc:ehl:lserod:456
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Web page: http://www.lse.ac.uk/

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