How does liquidity affect asset pricing?

Liquidity shapes asset prices by altering transaction costs, risk exposures, and the speed at which information is incorporated into market quotes. When markets are highly liquid, buyers and sellers can trade large quantities without moving prices much; when liquidity is scarce, the same trades generate larger price impact and greater dispersion between quoted and fundamental values. These effects change expected returns because investors demand compensation for trading frictions and for bearing exposure to variations in market liquidity.

Mechanisms linking liquidity to prices
Transaction costs such as bid-ask spreads and price impact reduce the net proceeds available to investors, effectively increasing the cost of holding or disposing of an asset. Yakov Amihud at New York University developed a widely used illiquidity metric showing that stocks with higher realized price impact per unit volume tend to deliver higher average returns, consistent with a cross-sectional liquidity premium. Beyond direct costs, liquidity interacts with risk: a security whose returns fall when aggregate market liquidity deteriorates exposes holders to an additional form of systematic risk. Lubos Pastor at Northwestern University and Robert F. Stambaugh at University of Pennsylvania documented that sensitivity to aggregate liquidity commands a premium in expected stock returns, indicating that liquidity risk is priced similarly to market or size risk.

Feedbacks and funding considerations
Market liquidity is not only a static friction but also interacts with funding conditions and investor behavior. Markus Brunnermeier at Princeton University and Lasse Pedersen at Copenhagen Business School describe how declines in funding liquidity—when lenders pull back or margin requirements tighten—can force asset sales that worsen market liquidity and depress prices further. This feedback loop amplifies price moves during stress, turning temporary shocks into persistent mispricing. The consequence is that asset prices reflect both fundamental cash flows and the state of liquidity provision, which can vary across regions and asset classes.

Empirical relevance and consequences for markets and investors
Evidence from equities, bonds, and emerging markets shows consistent liquidity effects. In less developed markets or during crises, wider spreads and lower depth mean liquidity premia are larger, affecting capital costs for firms and the net returns earned by savers. For long-term institutional investors such as pension funds and insurers, liquidity characteristics influence portfolio choice: assets that offer higher yields may do so because they are harder to trade, creating a trade-off between return and operational flexibility. For households and local economies, constrained liquidity during downturns can raise borrowing costs for firms and reduce investment, with tangible consequences for employment and growth.

Implications for policy and market design
Because liquidity influences asset allocation and financial stability, regulators and market designers pay attention to market-making incentives, minimum quote requirements, and central bank backstops that can restore liquidity in stress. Understanding the measurable link between liquidity and prices, documented by researchers such as Yakov Amihud New York University, Lubos Pastor Northwestern University, Robert F. Stambaugh University of Pennsylvania, Markus Brunnermeier Princeton University, and Lasse Pedersen Copenhagen Business School, helps align market structure with the needs of both everyday investors and systemic stability.