Asset Pricing with Liquidity Risk

This paper solves explicitly an equilibrium asset pricing model with liquidity risk -the risk arising from unpredictable changes in liquidity over time.In our liquidity-adjusted capital asset pricing model, a security's required return depends on its expected liquidity as well as on the covariances of its own return and liquidity with market return and market liquidity.In addition, the model shows how a negative shock to a security's liquidity, if it is persistent, results in low contemporaneous returns and high predicted future returns.The model provides a simple, unified framework for understanding the various channels through which liquidity risk may affect asset prices.Our empirical results shed light on the total and relative economic significance of these channels.