FIN-03-044

Asset Pricing with Liquidity Risk

July 2003

Viral V. Acharya and Lasse Heje Pedersen

ABSTRACT
This paper studies equilibrium asset pricing with liquidity risk | the risk arising from unpredictable changes in liquidity over time. It is shown that a security’s required return depends on its expected illiquidity and on the covariances of its own return and illiquidity with market return and market illiquidity. This gives rise to a liquidity- adjusted capital asset pricing model. Further, if a security’s liquidity is persistent, a shock to its illiquidity results in low contemporaneous returns and high predicted future returns. Empirical evidence based on cross-sectional tests is consistent with liquidity risk being priced.

Viral V. Acharya
Institution: : London Business School, Regent’s Park, London - NW1 4SA, UK
Phone: +44 (0) 20-7262-5050 x3535
Fax: +44 (0) 20-7724-3317
Email: vacharya@london.edu
Home Page: http://www.london.edu/faculty/vacharya

Lasse Heje Pedersen
Institution: Stern School of Business, New York University
Phone: (212) 998-0359
Fax: (212) 995-4233
Email: lpederse@stern.nyu.edu
Home Page: http://www.stern.nyu.edu/~lpederse

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