Abstract

Among the field of asset pricing theory, the theoretical significance of market liquidity risk premium is a hot topic. This paper decomposes market liquidity risk into exogenous and endogenous liquidity risk, and introduces liquidity demand as a state variable, giving rise to the random holding horizon, and develops a liquidity risk-adjusted capital asset pricing model. Besides agreement with the previous theoretical literatures about the effect of exogenous liquidity risk on asset pricing, we find that different elasticity value of price impact can make a cross-sectional dispersion in required return for the level of liquidity and market liquidity risk. The state variable of liquidity demand affects market liquidity risk premium increasingly, and could induce the known time-varying phenomenon of liquidity risk premium.

Key words: Liquidity risk, liquidity demand, asset pricing.