By Dion Bongaerts, Frank de Jong and Joost Driessen
Abstract:
We derive an equilibrium asset pricing model incorporating liquidity risk, derivatives, and short-selling due to hedging of non-traded risk. We show that illiquid assets can have lower expected returns if the short-sellers have more wealth, lower risk aversion or shorter horizon. The pricing of liquidity risk is different for derivatives than for positive-net-supply assets, and depends on the investors’ net non-traded risk exposure. We estimate this model for the credit default swap market using GMM. We find strong evidence for an expected liquidity premium earned by the credit protection seller. The effect of liquidity risk is significant but economically small.
Forthcoming in The Journal of Finance.
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