Stock and Bond Pricing with Liquidity Risk

Abstract

The paper tests the liquidity linkage between the stock and Treasury bond markets and its implications for asset pricing. We find that liquidity has a cross-market effect, which we attribute to trading activity across markets. We show that stock returns contain not only an illiquidity premium of the stock market as has been documented in the literature, but also an illiquidity premium of the bond market. A difference of 10 percentage points in the exposure to bond illiquidity risk between two stocks translates into a difference of 7 to 9 percent in their expected returns per year. Bond returns also contain an illiquidity premium of both the stock and bond markets. We document that the illiquidity of the stock market and/or unexpected shock to the bond market illiquidity dominate the momentum factor in the Carhart's (1997) four-factor model. We introduce a five-factor model. Finally, we test the cross-market liquidity effect within an arbitrage-free affine joint stock and bond pricing model with stock and bond market liquidity included in the vector of state variables, and find support for the model. Under the model's restrictions, a 10 percentage points change in the stock illiquidity leads to 1.4% change in the risk free rate per year. Overall, the paper contributes to the integration between stock and bond markets.