Abstract
We show that illiquidity risk matters for asset pricing independently of the specific functional form of the liquidity-based asset pricing model. Employing a non-parametric model-free stochastic discount factor (SDF), estimated using different sets of portfolio returns coming from both the stock and the corporate bond markets, we show that market-wide illiquidity affects positive and significantly the volatility of the SDF. This finding is robust to the use of alternative market-wide illiquidity metrics and persists after we control for GARCH effects on the short-term component of the SDF’s volatility. Overall, our analysis shows that market-wide illiquidity is a relevant driver of the time-varying behavior of the assets’ risk premium.
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