A Review of Liquidity Premium

Abstract

This paper reviews studies of the liquidity issue in finance literatures.  Liquidity imposes a premium on efficient asset returns in two different forms: liquidity costs and liquidity risks.  The former is simply a transaction cost resulting from a bid-ask spread while the latter involves the volatility of liquidity levels that inflicts systematic and unsystematic risks on asset returns.  Even with varying proposed proxies of unobservable liquidity levels, liquidity premiums on asset returns is evidenced by most studies.  Empirically, a more critical issue besides measuring liquidity level is the estimating error of the market price of risk resulting from applying CAPM-type models that needs further attentions.  While recent theoretical advancements on the liquidity issue give weight to developing liquidity (risk)-adjusted asset pricing models to address this issue, the increasing applications for risk management demand sophisticated dynamic modeling of liquidity risk, the area which is still well undeveloped that should emerge as a new active research area.

            Most asset pricing models are idealistically built on the assumptions of perfect market that ignore trading and transaction factors which predominate in the real world.  Both factors project both liquidity costs and risks that influence asset prices.  In addition, financial crises, transmissions of monetary policy, flight-to-quality among assets, size of stock floatations, market maker activities, etc. are among familiar episodes of liquidity shocks that most models fail to capture explicitly.  Liquidity shocks that are common in the financial market impose significant influence on asset prices at two levels: macro liquidity (or marketwide liquidity) that systematically affects every asset, and micro liquidity (or transactions liquidity) that characterizes each individual asset’s liquidity.