Liquidity Discovery and Asset Pricing

Asset prices are random, in part, because of uncertainty about the preferences of potential counterparties and their future demands for securities. We call such randomness liquidity risk. We model the endogenous dynamics of liquidity risk, the risk premium for bearing liquidity risk, and the role of market trading in the liquidity discovery process through which investors form expectations about future liquidity. Our model also provides explanations for “price support levels ” and “flights to quality.