The role of liquidity in asset pricing has attracted considerable attention in recent years. Liquidity risk is often used by researchers to account for the portion of market prices that is unexplained by existing pricing models. In the bond literature, it has long been acknowledged that credit risk alone cannot capture the level of corporate bond yield spreads, and thus liquidity has been introduced to explain this so-called “credit spread puzzle”. Investors demand a liquidity premium for holding illiquid securities, such as corporate bonds, thus increasing the level of spreads beyond what is explained by default risk (Elton et al., 2001).
There is strong evidence indicating that liquidity impacts asset returns through individual security characteristics (see Amihud and Mendelson, 1986, 1989; Brennan and Subrahmanyam, 1996; Brennan et al., 1998; Amihud, 2002; and Chen, Lesmond, and Wei, 2005) or as a systematic risk factor (see Pastor and Stambaugh, 2003; and Sadka, 2005). Acharya and Pedersen (2005), motivated by previous empirical findings, present an equilibrium model with liquidity risk. Their Liquidity-Adjusted Capital Asset Pricing Model (LCAPM) captures multiple components of liquidity risk. Using U.S. stock market data, they show that their model is supported by the data.
Collin-Dufresne et al.’s (2001) show that residuals from their regression analysis for the determinants of yield spread changes (offered by traditional pricing models) are driven by a common factor. We assert that this common factor can be explained by the LCAPM’s liquidity betas that relate asset specific return/liquidity to market wide return/liquidity. Therefore, the current paper extends the application of the LCAPM to the corporate bond market. We show that various sources of liquidity risk are priced in this market. To our knowledge, this is the first paper to demonstrate the impact of systematic liquidity risk (together with liquidity costs) on pricing in the corporate bond market. Therefore, we offer a unique explanation to the credit-spread puzzle and for the common factor that drives corporate bond yield spreads.
Most research in the asset pricing and liquidity literature has focused on the U.S. equity market. This is not surprising, given the availability of accessible and reliable high-frequency equity data. More recent work in this area explores the impact of liquidity on corporate bond prices. Since the corporate bond market is substantially less liquid than the equity or Treasury markets, it provides a natural setting to examine the impact of liquidity on asset prices.
