How Illiquidity Costs and Liquidity Risk Affect Asset Prices

Summary

The document describes why illiquidity can affect asset prices and returns. Transaction costs such as taxes and brokerage fees act as market frictions; investors may require compensation for bearing them, which can influence the prices they are willing to pay. The answer places this idea within liquidity and asset pricing research, where frictions are incorporated into explanations of returns.

It notes that liquidity has been used to help explain empirical patterns including the small firm effect and the equity premium puzzle. It points readers toward market microstructure and liquidity-based asset pricing research, citing introductory and research references on liquidity risk and bid–ask spreads. The response is conceptual and bibliographic: it does not provide a specific pricing equation, quantify the effect, or establish that illiquidity alone explains those market patterns. The direction and size of any price or return effect depend on the costs and risks investors face.

Key ideas

• Investors may require compensation for transaction costs and other illiquidity frictions.
• Illiquidity can affect the prices investors are willing to pay and the returns they require.
• Liquidity-related explanations have been applied to the small firm effect and equity premium puzzle.
• Market microstructure and liquidity-based asset pricing are related research areas.
• The document gives references but no quantitative estimate or standalone pricing method.

Tags

# Liquidity and Prices


# Liquidity and Prices












Do fewer transaction costs and higher liquidity relate to lower market prices? Are there any good resources that deal with these topics in more detail?

## Answer by Malick (score 1)

https://quant.stackexchange.com/a/9997

You are right, "exogeneous transaction costs" (transaction taxes, brokerage fees...) are related to illiquidity sources. In the literature, these costs impact prices because investors require compensation for its cost.

Empirically, liquidity has been helpful to explain some market facts such that the small firm effect, the equity premium puzzle... Loosely speaking if you are interested in good material you have the choice either to study the literature (very large) on market microstructure or the literature on liquidity and asset pricing. In this latter literature, the market is seen as a friction market and illiquidity costs (frictions) are taken into accounts by investors. Then, returns (=prices) are impacted by illiquidity. A very good introduction to this literature is given in : Amihud, Y., Mendelson, H., & Heje Pedersen, L. (2005). Liquidity and Asset Prices . nowpublishers Inc.

Two others references :

Acharya, V., & Pedersen, L. (2005). Asset pricing with liquidity risk. Journal of Financial Economics,

Amihud, Y., & Mendelson, H. (1986). Asset pricing and the bid-ask spread. Journal of financial Economics, 17.

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