roniliquidity

roniliquidity - Future Liquidity Present Value Measuring...

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Unformatted text preview: Future Liquidity, Present Value: Measuring and Pricing Liquidity Risk Roni Israelov † November 18, 2006 Abstract Liquidity costs are not incurred once, but many times over the lifetime of an asset. Changes in forecasts of future liquidity levels impact contemporaneous prices. I derive two extensions of the Campbell (1991) return decomposition and decompose contemporaneous returns into revisions in expectations, or news, about future dividends, liquidity, and net discount rates. The two de- compositions consider, respectively, news about future proportional costs and news about future fixed costs. Using the decompositions, I find that (i) both fixed cost and proportional cost news are substantially more volatile than contemporaneous proportional costs, (ii) fixed cost news is an economically important contributor to portfolio volatility and proportional cost news is not, (iii) small and illiquid stocks have more volatile proportional and fixed cost news and low turnover stocks have more volatile proportional cost news risk and less volatile fixed cost news, and (iv) the market price of risk for both fixed and proportional cost news, estimated within the Liquidity-Adjusted CAPM framework of Acharya and Pedersen (2005), is not statistically different than the price of non-liquidity risk. JEL classification: G0; G1; G12. Keywords: Liquidity; Liquidity risk; Liquidity premium; Transaction costs. † Tepper School of Business, Carnegie Mellon University 5000 Forbes Avenue, Pittsburgh, PA 15213, USA Email: [email protected] Phone: (412) 606-2796 I am grateful to Richard Green, Burton Hollifield, ˇ Luboˇ s P´astor, and Duane Seppi for comments and suggestions. 1 Introduction In their extensive survey of the liquidity literature, Amihud, Mendelson, and Pedersen (2005) write “Liquidity varies over time. This means that investors are uncertain what transactions cost they will incur in the future when they need to sell an asset. Further, since liquidity affects the level of prices, liquidity fluctuations can affect the asset price volatility itself.” This paper joins the growing body of research that studies the effect of liquidity risk on expected returns, but it begins with an investigation of the effect of liquidity fluctuations on asset price volatility. Amihud (2002) reports that negative shocks to liquidity lower asset prices. Acharya and Pedersen (2005) report a negative relationship between unexpected market illiquidity and asset returns, and between unexpected asset illiquidity and market returns. How much of an asset’s volatility can be attributed to these liquidity fluctuations? A similar question can be, and has been, asked about dividend fluctuations. Campbell (1991) answers the question by decomposing the unexpected contemporaneous return into two components, new information about the dividend stream and new information about future discount rates. Even though uncertainty about contemporaneous cash flows is relatively low, using the decomposition,...
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roniliquidity - Future Liquidity Present Value Measuring...

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