Abstract: "An agent solves an infinite-horizon consumption-investment problem when the investment possibilities are a constant-interest-rate, risk-free asset and a stock, modelled as a geometric Brownian motion. There are proportional transaction costs associated with moving wealth between these two assets. The direct utility for consumption is of the form 1/p c[superscript p] for some p [element of] (0,1). The sensitivity of the indirect utility function (or value function) to small transaction costs is found to be of the order of the transaction cost to the 2/3 power."

Liquidity and Asset Prices reviews the literature that studies the relationship between liquidity and asset prices. The authors review the theoretical literature that predicts how liquidity affects a security's required return and discuss the empirical connection between the two. Liquidity and Asset Prices surveys the theory of liquidity-based asset pricing followed by the empirical evidence. The theory section proceeds from basic models with exogenous holding periods to those that incorporate additional elements of risk and endogenous holding periods. The empirical section reviews the evidence on the liquidity premium for stocks, bonds, and other financial assets.

This book presents the theory and evidence on the effect of market liquidity and liquidity risk on asset prices and on overall securities market performance. Illiquidity means incurring a high transaction cost, which includes a large price impact when trading and facing a long time to unload a large position. Liquidity risk is higher if a security becomes more illiquid when it needs to be traded in the future, which will raise trading cost. The book shows that higher illiquidity and greater liquidity risk reduce securities prices and raise the expected return that investors require as compensation. Aggregate market liquidity is linked to funding liquidity, which affects the provision of liquidity services. When these become constrained, there is a liquidity crisis which leads to downward price and liquidity spiral. Overall, the volume demonstrates the important role of liquidity in asset pricing.

In this article we study the effects of transaction costs on asset prices. We assume an overlapping generations economy with two riskless assets. The first asset is liquid while the second asset carries proportional transaction costs. We show that agents buy the liquid asset for short-term investment and the illiquid asset for long-term investment. When transaction costs increase, the price of the liquid asset increases. The price of the illiquid asset decreases if the asset is in small supply, but may increase if the supply is large. These results have implications for the effects of transaction taxes and commission deregulation.

Brings together today's best financial minds across the world to discuss the issue of liquidity in today's markets. It is often proxied by trade-based measures (such as trading volume, frequency of trading, dollar value of shares trade, etc), order based measures and price impact measures.

This paper examines the role of liquidity risk in explaining the cross-section of asset returns using a new measure of liquidity that captures its multi-dimensional nature. This new measure earns a robust liquidity premium that the CAPM and the Fama-French three-factor model cannot explain. I find that a two-factor (market and liquidity) model performs better in explaining the cross-section of stock returns than the CAPM and the Fama-French three-factor model. It not only describes the liquidity premium, but it also subsumes documented anomalies associated with size, book-to-market, cashflow-to-price, earnings-to-price, dividend yield, and long-term contrarian investment. The model also accounts for price momentum after taking into account transaction costs.