LIQUIDITY-ADJUSTED ASSET

PRICING MODEL
Nabil Aquedim
Ismail Belhachmi
 Liquidity Adjusted Asset Pricing Model 2

Review of the CAPM

The CAPM implies that the expected return of an asset is

linearly correlated to the covariance of its return with the
return of a market portfolio:

𝐸 𝑅𝑖 = 𝑅𝑓 + 𝛽𝑖𝑚 𝐸[𝑅𝑚 − 𝑅𝑓 ]
 Liquidity Adjusted Asset Pricing Model 3

Example of Liquidity Crisis

• Current crisis
• 1998 LTCM
• 1997 Asian Crisis
• 1987 Stock market crash and merger arbitrage

Necessity of models taking into account liquidity

parameters
 Liquidity Adjusted Asset Pricing Model 4

Model Assumptions
• N securities indexed by i=1…N
• Each security has a total shares of Si
• At time t, security i :
 Pays a dividend of 𝐷𝑡𝑖
 Has an ex-dividend share price of 𝑃𝑡𝑖
 Has an illiquidity cost of 𝐶𝑡𝑖 modeled as the per-share cost of
selling a security

Equivalence with an economy where assets have a dividend of

𝐷𝑡𝑖 − 𝐶𝑡𝑖 and no illiquidity cost
 Liquidity Adjusted Asset Pricing Model 5

Model Assumptions

𝐷𝑡𝑖 and 𝐶𝑡𝑖 are AR(1) processes:

𝐷𝑡 = 𝐷 + 𝜌𝐷 𝐷𝑡 − 1 − 𝐷 + 𝜀𝑡
𝐶𝑡 = 𝐶 + 𝜌𝐶 𝐶𝑡 − 1 − 𝐶 + η𝑡

Σ𝐷 Σ𝐶𝐷
with (𝜀𝑡 , η𝑡)~ 𝑁 0, 𝐶𝐷
Σ Σ𝐶
 Liquidity Adjusted Asset Pricing Model 6

The Liquidity-Adjusted Pricing Model (1)

𝑃𝑡𝑖 +𝐷𝑡𝑖
• Stock’s gross return: 𝑟𝑡𝑖 = 𝑖
𝑃𝑡−1

𝐶𝑡𝑖
• Stock’s relative illiquidity: 𝑐𝑡𝑖 = 𝑖
𝑃𝑡−1

𝑖𝑆
𝑖
(𝑃𝑡𝑖 +𝐷𝑡𝑖 )
• Market’s return: 𝑟𝑡𝑀 = 𝑖 𝑖
𝑖 𝑆 𝑃𝑡−1

𝑖𝑆
𝑖
𝐶𝑡𝑖
• Market’s relative illiquidity: 𝑐𝑡𝑀 = 𝑖 𝑖
𝑖 𝑆 𝑃𝑡−1

• In the “equivalent economy”:

𝑃𝑡𝑖 +𝐷𝑡𝑖 −𝐶𝑡𝑖

𝑟𝑡𝑖,𝑛𝑒𝑡 = 𝑖 = 𝑟 𝑖 - 𝑐𝑡𝑖
𝑡
𝑃𝑡−1
𝑖 𝑖 𝑖 𝑖
𝑖 𝑆 (𝑃𝑡 +𝐷𝑡 −𝐶𝑡 )
𝑐𝑡𝑖,𝑛𝑒𝑡 = 𝑖 𝑖 = 𝑟𝑡𝑀 - 𝑐𝑡𝑀
𝑖 𝑆 𝑃𝑡−1
 Liquidity Adjusted Asset Pricing Model 7

The Liquidity-Adjusted Pricing Model (2)

Since CAPM holds in the equivalent economy:
𝑖,𝑛𝑒𝑡
𝔼𝑡 𝑟𝑡+1 = 𝑟𝑓 + 𝛽𝑡𝑖,𝑚 𝔼𝑡 𝑟𝑡+1
𝑀,𝑛𝑒𝑡
− 𝑟𝑓
𝑖,𝑛𝑒𝑡 𝑀,𝑛𝑒𝑡
𝑖,𝑚 𝑐𝑜𝑣𝑡(𝑟𝑡+1 ,𝑟𝑡+1 )
𝑤𝑖𝑡ℎ: 𝛽𝑡 =
𝑉𝑎𝑟 (𝑟 𝑀,𝑛𝑒𝑡 )
𝑡 𝑡+1

𝑖
𝔼𝑡 𝑟𝑡+1 𝑖
−𝑐𝑡+1 = 𝑟𝑓 + 𝛽𝑡𝑖,𝑚 𝔼𝑡 𝑟𝑡+1
𝑀 𝑀
−𝑐𝑡+1 −𝑟𝑓
𝑖 𝑖 𝑀 𝑀
𝑖,𝑚 𝑐𝑜𝑣𝑡 (𝑟𝑡+1 −𝑐𝑡+1 , 𝑟𝑡+1 −𝑐𝑡+1 )
𝑤𝑖𝑡ℎ: 𝛽𝑡 = 𝑀 𝑀
𝑉𝑎𝑟𝑡(𝑟𝑡+1 −𝑐𝑡+1 )
 Liquidity Adjusted Asset Pricing Model 8

The Liquidity-Adjusted Pricing Model (3)

By expanding:
𝑖 𝑀
𝑖
𝔼𝑡 𝑟𝑡+1 𝑖
) = 𝑟𝑓 + 𝔼𝑡(𝑐𝑡+1 𝑀
+ 𝔼𝑡 𝑟𝑡+1 𝑀
−𝑐𝑡+1 −𝑟𝑓 [ 𝑐𝑜𝑣𝑡(𝑟𝑡+1 ,𝑟𝑡+1
𝑀 −𝑐 𝑀 ) +
𝑉𝑎𝑟𝑡(𝑟𝑡+1 𝑡+1
)

𝑖 𝑀 𝑖 𝑀 𝑖 𝑀
𝑐𝑜𝑣𝑡(𝑐𝑡+1 ,𝑐𝑡+1
𝑀 −𝑐 𝑀 )
𝑉𝑎𝑟𝑡 (𝑟𝑡+1 𝑡+1
)
−
𝑐𝑜𝑣𝑡 (𝑟𝑡+1 ,𝑐𝑡+1
𝑀 −𝑐 𝑀 )
𝑉𝑎𝑟𝑡 (𝑟𝑡+1 𝑡+1
)
−
𝑐𝑜𝑣𝑡(𝑐𝑡+1 ,𝑟𝑡+1
𝑀 −𝑐 𝑀 )
𝑉𝑎𝑟𝑡(𝑟𝑡+1 𝑡+1
)
]
 Liquidity Adjusted Asset Pricing Model 9

Three Liquidity Risks

𝑖 𝑖
𝔼𝑡 𝑟𝑡+1 ) = 𝑟𝑓 + 𝔼𝑡 (𝑐𝑡+1 + 𝜆𝑡[ 𝛽𝑡1 + 𝛽𝑡2 - 𝛽𝑡3 - 𝛽𝑡4 ]
𝑖 𝑀
𝛽𝑡1 ~ 𝑐𝑜𝑣𝑡(𝑟𝑡+1 , 𝑟𝑡+1 ): Market Risk
𝑖 𝑀
𝛽𝑡2
~ 𝑐𝑜𝑣 𝑡 𝑡+1 𝑡+1 ): Commonality in liquidity with the
(𝑐 , 𝑐
market
𝑖
𝛽𝑡3 ~ 𝑐𝑜𝑣𝑡(𝑟𝑡+1 𝑀
, 𝑐𝑡+1 ): Return sensitivity to market liquidity
𝑖 𝑀
𝛽𝑡4 𝑐𝑜𝑣𝑡(𝑐𝑡+1
~ , 𝑟𝑡+1 ): Liquidity sensitivity to market
returns
 Liquidity Adjusted Asset Pricing Model 10

An Unconditional Liquidity-Adjusted
CAPM
• For estimation reasons, we derive an unconditional
version:
• We use 𝔼 𝑐𝑜𝑣𝑡 𝑋, 𝑌 = 𝑐𝑜𝑣(𝑋 − 𝔼t X , 𝑌 − 𝔼t Y )
• We found that:
𝑓
𝔼 𝑟𝑡𝑖 − 𝑟𝑡 = 𝔼 𝑐𝑡𝑖 + 𝜆𝛽1𝑖 + 𝜆𝛽2𝑖 − 𝜆𝛽3𝑖 − 𝜆𝛽4𝑖
Where:
𝑐𝑜𝑣(𝑟𝑡𝑖 , 𝑟𝑡𝑀 − 𝔼𝑡−1 𝑟𝑡𝑀 )
𝛽1𝑖 =
𝑣𝑎𝑟(𝑟𝑡𝑀 − 𝔼𝑡−1 𝑟𝑡𝑀 − [𝑐𝑡𝑀 −𝔼𝑡−1 𝑐𝑡𝑀 ])
𝑐𝑜𝑣(𝑟𝑡𝑖 − 𝔼𝑡−1 𝑟𝑡𝑖 , 𝑐𝑡𝑀 − 𝔼𝑡−1 𝑐𝑡𝑀 )
𝛽 2𝑖 =
𝑣𝑎𝑟(𝑟𝑡𝑀 − 𝔼𝑡−1 𝑟𝑡𝑀 − [𝑐𝑡𝑀 −𝔼𝑡−1 𝑐𝑡𝑀 ])
𝑐𝑜𝑣(𝑟𝑡𝑖 , 𝑐𝑡𝑀 − 𝔼𝑡−1 𝑐𝑡𝑀 )
𝛽 3𝑖 =
𝑣𝑎𝑟(𝑟𝑡𝑀 − 𝔼𝑡−1 𝑟𝑡𝑀 − [𝑐𝑡𝑀 −𝔼𝑡−1 𝑐𝑡𝑀 ])
𝑐𝑜𝑣(𝑐𝑡𝑖 − 𝔼𝑡−1 𝑐𝑡𝑖 , 𝑟𝑡𝑀 − 𝔼𝑡−1 𝑟𝑡𝑀 )
𝛽 4𝑖 =
𝑣𝑎𝑟(𝑟𝑡𝑀 − 𝔼𝑡−1 𝑟𝑡𝑀 − [𝑐𝑡𝑀 −𝔼𝑡−1 𝑐𝑡𝑀 ])
 Liquidity Adjusted Asset Pricing Model 11

Empirical Tests

• The Protocol:
• Defining a reliable measure illiquidity
• Defining diffrent portfolios to test the model

• Two Main Hypothesis to test:

• Consistence of the three Betas with market observations
• How liquidity affects returns
 Liquidity Adjusted Asset Pricing Model 12

Defining Portfolios to Test

• Two groups of 25 portfolios:

• Illiquidity portfolios: Stocks are sorted in 25 portfolios according to
their computed annual illiquidity
• Illiquidity-variation portfolio: Stocks are sorted in 25 portfolios
according to the standard deviation of their daily illiquidity

• We define a portfolio illiquidity and return by:

𝑝
𝑟𝑡 = 𝑤𝑡𝑖𝑃 𝑟𝑡𝑖
𝑖 𝑖𝑛 𝑃
𝑝
𝑐𝑡 = 𝑤𝑡𝑖𝑃 𝑐𝑡𝑖
𝑖 𝑖𝑛 𝑃
 Liquidity Adjusted Asset Pricing Model 13

A Reliable Illiquidity Measure (1)

• Bid-Ask spreads are not available for the usually desirable period :
A new measure depending on returns and volumes:
𝐷𝑎𝑦𝑠𝑡𝑖 𝑖
1 𝑅𝑡𝑑
𝐼𝐿𝐿𝐼𝑄𝑡𝑖 =
𝐷𝑎𝑦𝑠𝑡𝑖 𝑖
𝑉𝑡𝑑
𝑑=1
Where:
Ritd :The return on day d in month t
i :The volume on day d in month t
Vtd
Daysti : Number of valid observation days in month t for stock i

This measure is not stationnary and fails to directly measure the

cost of trade (only selling cost)
 Liquidity Adjusted Asset Pricing Model 14

A reliable illiquidity measure(2)

• The authors define a normalized measure of illiquidity:
𝑖
𝑐𝑡𝑖 = min 0,25 + 0,30 𝐼𝐿𝐿𝐼𝑄𝑡𝑖 𝑃𝑡−1 , 30,00
• To modelize the innovation illiquidity, we opt for an AR(2)
process:

𝑃 𝑃
𝑐𝑡𝑃 = 𝑎0 + 𝑎1𝑐𝑡−1 + 𝑎2𝑐𝑡−2 + 𝑢𝑡
 Liquidity Adjusted Asset Pricing Model 15

Main Results
• The estimated illiquidities were high during periods that
were characterized by a liquidity crisis (1987, 1990,
December 1997, October 1998)

• Liquidity risk and returns:t he return of a security i is:

• Increasing in the covariance of its liquidity & market illiquidity
𝑖 𝑀
𝑐𝑜𝑣𝑡 (𝑐𝑡+1 , 𝑐𝑡+1 )
• Decreasing in both:
• The covariance between the security return and market illiquidity
𝑖 𝑀
𝑐𝑜𝑣𝑡 (𝑟𝑡+1 , 𝑐𝑡+1 )
• The covariance between its liquidity and the market return
𝑖 𝑀
𝑐𝑜𝑣𝑡 (𝑐𝑡+1 , 𝑟𝑡+1 )
 Liquidity Adjusted Asset Pricing Model 16

Next Steps

• Implement the model

• Find the data to test it
• Backtest it on a real situation (convertible bonds in 2008
for e.g.)
• Explore the equivalence CAPM / Black-Scholes and
derive a liquidity-adjusted Black-Scholes model
• Liquidity-adjusted pricing formulas for some securities