Liquidity And Asset Pricing: Theoretical Interpretation And Empirical Evidences

Liquidity pricing is a heated issue in financial economics in recent years. So far the theoretical framework of liquidity pricing is hardly near perfect and empirical evidences of liquidity pricing are inconsistent, sometimes even conflicting. This thesis attempts to construct a theoretical model to provide reasonable explanations for liquidity pricing, and to make empirical tests in Chinese stock market on propositions resulting from the model.In view of the economic essence of assets trading, this thesis proposes that liquidity should be defined as the extent to which the future income can convert into present income. Based on this definition of liquidity, this thesis sets up a theoretical model which employs state-dependence of utility as basic presumption and the consumption-based capital assets pricing model as theoretical prototype. The model shows that nonreversibility of time is the ultimate driver of non-negative liquidity premium, the max pay-will of an individual consumer depends on the variance of consumption state and the systematic driver of consumption states is the main contributing factor of benchmark liquidity premium. In a perfect market, the persistency of asset market, the asset trading costs and information cost form the three basic dimensions of asset liquidity, and the differences on these dimensions between assets result in cross-sectional differences of liquidity premium. Besides, the analysis after uncertainty of future income and liquidity are introduced into the model shows that the risk-averse of liquidity providers and liquidity demanders result in positive relationship between not only idiosyncratic risk and expected return of asset, but also idiosyncratic risk and asset turnover. Furthermore, different structures of liquidity risks lead to different characters of the relationship between measures of liquidity risk and expected return of assets.Based on theoretical analyses above, this thesis tests the relationship between liquidity and expected return through an empirical test of the relationship between the unexpected liquidity innovation and concurrent stock returns in Chinese stock market, in which relative bid-ask spread, quoted depth and trading frequency are used as proxies of liquidity and time-series regression methods are employed. And test results are as expected. Further studies find some other evidences. First, idiosyncratic risk and turnover of stocks are positively related. Second, idiosyncratic risk and expected return of stocks are negatively related. Last but not the least, the covariance between stock liquidity and systematic liquidity, stock return and systematic liquidity, stock liquidity and market return have little explanatory power on cross-sectional stock return, but the volatility of stock liquidity does have significant influence on stock expected return.