A Note on the Pricing of Liquidity in Stock Returns

Abstract

Keynes (1930) proposed that an asset is more liquid than another “if it is more certainly realisable at short notice without loss” (vol. II, p. 67). This definition suggests that the liquidity of an asset is twofold. First, an asset should have a market that can readily absorb the sale, and second, do so without risk to its final value. This suggests that investors should be rewarded for both the level of liquidity and liquidity risk. The standard form of asset pricing models assumes financial markets to be perfectly liquid. In a perfectly liquid market, there are no arbitrage possibilities. Therefore, the under traditional asset pricing approach, all assets that have similar expected cash flows must have the same price. This phenomenon of frictionless markets ignores the impact of liquidity of financial assets on their respective prices and consequently on returns. The relation between liquidity and expected returns has been statistically observed and explains certain market anomalies such as the small firm effect, equity premium, and risk-free rate puzzle.