Hedging Against Liquidity Risk and Short Sale Constraints

Abstract

This paper exploits the intuition of the ICAPM to propose a measure that formally compares the empirical performance of competing asset pricing models in the presence of short selling constraints. In a multifactor context, portfolios are said to be efficient if they yield the highest expected return for a given variance and for a given degree of sensitivity to state variables that capture future investment-consumption risks. The measure of model misspecification is the maximal expected return loss caused by holding the market portfolio instead of the multifactor efficient portfolio. Including a proxy for liquidity in intertemporal pricing models takes the market portfolio closer to multifactor efficiency relative to scenarios that discard liquidity. Indeed, when no short positions are allowed, including a liquidity proxy in an intertemporal asset pricing model results in near exact multifactor efficiency of the market portfolio. Our empirical results can be explained by noting that liquidity risk is typically of major concern whenever the market declines. Investors who take short positions implicitly hedge against liquidity risk, thus a proxy for liquidity plays only a secondary role when such positions are allowed. In contrast, the liquidity proxy plays a major role when short selling is precluded.