Liquidity Risk and Asset Pricing: The Multivariate GARCH-in-Mean Application

Abstract

In this paper, the concept of liquidity risk in the sense of asset pricing is discussed firstly, and then all the liquidity risks are analyzed from two different aspects. From the whole market, there are two liquidity risks, namely, market returns sensitivity to aggregate liquidity level and volatility of aggregate liquidity level, while from the point of portfolio or individual security, there are four liquidity risks, namely, systematic liquidity risk, portfolio return sensitivity to market liquidity, portfolio liquidity sensitivity to market returns and volatility of portfolio liquidity level. Finally, a uniform model-the multivariate GARCH-in-mean is defined to investigate the relationship between all liquidity risks of two aspects and asset pricing. And the model also includes the impact of market risk, systematic risk and idiosyncratic risk on asset pricing.