How does liquidity risk affect asset pricing?

Liquidity risk alters asset pricing by changing expected returns, price formation, and trading behavior in ways that reflect the costs and uncertainty of converting positions into cash. When markets are less liquid, investors demand compensation for the higher cost of trading and the risk that market liquidity will dry up when they need to sell. That compensation appears as lower current prices or higher expected returns for assets that are harder to trade or that correlate with aggregate liquidity conditions.

Mechanics of liquidity risk

Theoretical models and empirical measures clarify the channels. Albert S. Kyle of the Massachusetts Institute of Technology formulated a model in which limited market depth and informed trading create price impact: trades move prices and larger orders incur greater cost. Yakov Amihud of New York University Stern introduced an illiquidity measure that links daily absolute returns to trading volume and demonstrated that stocks with higher measured illiquidity earn higher average returns, consistent with a liquidity premium. Yakov Amihud and Haim Mendelson of the University of Chicago also showed that bid-ask spreads and trading costs influence required returns, because investors must be compensated for direct transaction costs and for the price concessions needed to execute trades quickly.

Time variation in liquidity is central. Lubos Pastor of University of Chicago Booth and Robert F. Stambaugh of the University of Pennsylvania Wharton documented that sensitivity of individual stock returns to innovations in aggregate market liquidity predicts cross-sectional expected returns. In other words, an asset’s exposure to a marketwide deterioration in liquidity functions like a systematic risk factor: when liquidity falls broadly, investors who hold assets that suffer larger relative liquidity shocks require greater return premia.

Consequences for investors, markets, and policy

For portfolio managers, liquidity risk means that traditional return measures understate the true cost of holding and transacting assets. Liquidity-adjusted performance evaluation and stress testing that incorporate likely transaction costs and the potential for sudden liquidity evaporation become necessary. For firms, limited secondary-market liquidity raises the cost of raising capital because investors demand a premium for holding less tradable claims; that influences corporate financing choices and can depress valuations for small or thinly traded firms.

Market structure and territorial context matter. Less developed and frontier markets typically exhibit higher baseline illiquidity and larger liquidity risk premia, reflecting lower participation, weaker infrastructure, and regulatory differences. Cultural practices such as concentrated ownership or informal trading networks can further constrain tradability in specific regions or sectors, amplifying local price effects. During crises, liquidity risk can cascade into fire sales and amplified price declines, a pattern visible in the 2007–2009 stress period when central banks and regulators intervened to restore functioning markets and reduce the transmission of liquidity shocks into solvency failures.

Understanding liquidity risk therefore requires combining theoretical models of price impact with empirical measures of trading costs and marketwide liquidity conditions. Recognizing the role of liquidity as a priced risk factor improves asset valuation, informs regulatory design, and sharpens risk management, particularly for investors and policymakers operating in markets where trading capacity is uneven across assets, participants, and territories.