Liquidity and Asset Pricing

Abstract

Portfolio managers strive to tailor portfolios to match the liquidity preferences of investors (Hodrick & Moulton, 2009; Reilly & Brown, 2011). Given the significance of liquidity in influencing investment decisions, it has received much- needed attention in financial research (O'Hara, 2003). The existence of liquidity, its different sources, and its relationship to asset prices are the focus of this dissertation. Multiple liquidity sources can affect asset prices. One such source is exogenous transaction costs. These are costs incurred to trade an asset, including the fee paid to brokers and bid-ask spreads (Jacoby, 2000). During the trading of a security, the seller or the buyer incurs a cost, and additional costs are expected throughout the trading lifetime of assets. Liquidity also comes from demand stress. Demand stress emerges when not all traders in the securities industry are always present. (Elliott, 2015). This suggests that buyers may not buy an asset when an agent needs to sell quickly. Accordingly, an intermediary may buy the asset in anticipation of a future sale, but the intermediary requires compensation for the risk of exposure to price fluctuations during the holding of the stocks. (Elliott, 2015). This pressure imposes additional costs, e.g., a higher bid-ask spread to the seller.