Stock Prices, Changes in Liquidity, and Liquidity Premia

Abstract

This paper develops a present-value framework that factors in expectations of future market illiquidity. Our framework can infer the implied liquidity premium inherent in the CRSP market portfolio, and then tests whether it is the main source of price variation. We find that the liquidity premium is significantly priced over short horizons, whereas its long-horizon effect is not significant. This finding implies that shocks to market liquidity should be so transient that even its big liquidity-premium variation in the beginning cannot build over horizons toward a big price change. We reconcile our findings with the theoretical debate over the importance of time variation in market illiquidity on asset pricing.