Consumption, liquidity and the cross-sectional variation of expected returns

Elena Márquez (), Belén Nieto Doménech and Gonzalo Rubio Irigoyen
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Elena Márquez: Dpto. Economía Aplicada III
Belén Nieto Doménech: Universidad de Alicante
Gonzalo Rubio Irigoyen: Universidad del País Vasco

Working Papers. Serie AD from Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie)

Abstract: Recent papers in asset pricing have added a market-wide liquidity factor to traditional portfolio-based or factor models. However, none of these papers has reported any evidence on how aggregate liquidity behaves together with consumption growth risk. This paper covers this gap by providing a comprehensive analysis of the cross-sectional variation of average returns under ultimate consumption risk and market-wide illiquidity shocks. It derives closed-form expressions for consumption-based stochastic discount factors adjusted by aggregate illiquidity shocks and tests alternative model specifications. We find that market-wide illiquidity risk seems to be especially useful in explaining the size-based cross-sectional differences of average returns. We also find a strongly negative and highly significant illiquidity risk premium under recursive preferences for the first quarter of the year suggesting a time-varying behaviour of the market-wide illiquidity premium.

Keywords: stochastic discount factor; ultimate consumption risk; market-wide liquidity; illiquidity premium seasonality. (search for similar items in EconPapers)
JEL-codes: E44 G10 G12 (search for similar items in EconPapers)
Pages: 48 pages
Date: 2010-07
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http://www.ivie.es/downloads/docs/wpasad/wpasad-2010-24.pdf Fisrt version / Primera version, 2010 (application/pdf)

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Persistent link: https://EconPapers.repec.org/RePEc:ivi:wpasad:2010-24

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