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Consumption, liquidity and the cross-sectional variation of expected returns

Author

Listed:
  • Elena Márquez

    () (Dpto. Economía Aplicada III)

  • Belén Nieto Doménech

    (Universidad de Alicante)

  • Gonzalo Rubio Irigoyen

    (Universidad del País Vasco)

Abstract

Recent papers in asset pricing have added a market-wide liquidity factor to traditional portfolio-based or factor models. However, none of these papers has reported any evidence on how aggregate liquidity behaves together with consumption growth risk. This paper covers this gap by providing a comprehensive analysis of the cross-sectional variation of average returns under ultimate consumption risk and market-wide illiquidity shocks. It derives closed-form expressions for consumption-based stochastic discount factors adjusted by aggregate illiquidity shocks and tests alternative model specifications. We find that market-wide illiquidity risk seems to be especially useful in explaining the size-based cross-sectional differences of average returns. We also find a strongly negative and highly significant illiquidity risk premium under recursive preferences for the first quarter of the year suggesting a time-varying behaviour of the market-wide illiquidity premium.

Suggested Citation

  • Elena Márquez & Belén Nieto Doménech & Gonzalo Rubio Irigoyen, 2010. "Consumption, liquidity and the cross-sectional variation of expected returns," Working Papers. Serie AD 2010-24, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie).
  • Handle: RePEc:ivi:wpasad:2010-24
    as

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    File URL: http://www.ivie.es/downloads/docs/wpasad/wpasad-2010-24.pdf
    File Function: Fisrt version / Primera version, 2010
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    References listed on IDEAS

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    More about this item

    Keywords

    stochastic discount factor; ultimate consumption risk; market-wide liquidity; illiquidity premium seasonality.;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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