A Note on the Pricing of Liquidity in Stock Returns

Abstract

Keynes (1930) proposed that an asset is more liquid than another “if it is more certainly realisable at short notice without loss” (vol. II, p. 67). This definition suggests that the liquidity of an asset is twofold. First, an asset should have a market that can readily absorb the sale, and second, do so without risk to its final value. This suggests that investors should be rewarded for both the level of liquidity and liquidity risk. The standard form of asset pricing models assumes financial markets to be perfectly liquid. In a perfectly liquid market, there are no arbitrage possibilities. Therefore, the under traditional asset pricing approach, all assets that have similar expected cash flows must have the same price. This phenomenon of frictionless markets ignores the impact of liquidity of financial assets on their respective prices and consequently on returns. The relation between liquidity and expected returns has been statistically observed and explains certain market anomalies such as the small firm effect, equity premium, and risk-free rate puzzle. In a market with frictions, one source of illiquidity is transaction costs, which are ignored in the traditional asset pricing framework. Such costs might include brokerage fees, order processing costs, etc. Whenever a security is traded, the buyer and seller incur transaction costs. Moreover, the buyer will bear additional transaction costs whenever the security is further sold in the market. Apart from transaction costs, other sources of liquidity could be demand pressure and inventory risk. Demand pressure can be created in a market where buyers are not available, and to liquidate the position, the seller might have to settle for a much lower price. The factor of demand pressure might be worsened in the presence of circuit breakers in a continuously bearish market. If the prices hit the lower circuit, sellers will not be able to lay off their positions and this phenomenon will continue if, on the following days, prices continue to open on their lower