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

• Elena Márquez ^[1] ; Belén Nieto Doménech ^[2] ; Gonzalo Rubio Irigoyen ^[3]
  1. [1] Universidad Complutense de Madrid

     Universidad Complutense de Madrid

     Madrid, España

     
  2. [2] Universitat d'Alacant

     Universitat d'Alacant

     Alicante, España

     
  3. [3] Universidad CEU Cardenal Herrera

     Universidad CEU Cardenal Herrera

     Valencia, España

     

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• Localización: Working papers = Documentos de trabajo: Serie AD, Nº. 24, 2010, págs. 1-45
• Idioma: inglés
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• Resumen

  • 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.