On the Noncompensation for Illiquidity in Equilibrium Asset Returns

This paper studies the efiects of illiquidity on asset prices, emphasizing the microstructure view of market liquidity. We set up a static CARA-Gaussian model in which a risky asset is traded under imperfect competition. We flnd that traders’ portfolios difier from Pareto optimal risk sharing due to insufflcient liquidity provision in the market. The expected return of the risky asset, however, is identical to the return under perfect competition and thus re∞ects only a risk premium but no liquidity premium. This result contradicts the prediction of liquidity premia in asset pricing models on exogenous transaction costs.