Liquidity and Asset Prices

January 01, 2005
  • Contributors:

    Yakov Amihud, Haim Mendelson, Lasse H. Pedersen
  • Topic:

    Other Research

Foundations and Trends in Finance

Liquidity is a complex concept. Stated simply, it is the ease of trading a security. This survey reviews the literature that studies the relationship between liquidity and asset prices. We review the theoretical literature that predicts how liquidity affects a security’s required return and discuss the empirical connection between the two.

Liquidity has wide ranging effects on financial markets. As our survey shows theoretically and empirically, liquidity can explain the cross-section of assets with different liquidity, after controlling for other assets’ characteristics such as risk, and the time series relationship between liquidity and securities returns.

Liquidity helps explain why certain hard-to-trade securities are relatively cheap, the pricing of stocks and corporate bonds, the return on hedge funds, and the valuation of closed-end funds. It follows that liquidity can help explain a number of puzzles, such as why equities commanding high required returns (the equity premium puzzle), why liquid risk-free Treasuries have low required returns (the risk-free rate puzzle), and why small stocks that are typically illiquid earn high returns (the small-firm effect).



  • AQR Capital Management, LLC, (“AQR”) provide links to third-party websites only as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by us of any content or information contained within or accessible from the linked sites. If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which AQR.com has no control. In no event will AQR be responsible for any information or content within the linked sites or your use of the linked sites.

  • The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees.

    This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.

  • Certain publications may have been written prior to the author being an employee of AQR.