Who Is Afraid of Liquidity Risk?

Dynamic Portfolio Choice with Stochastic Illiquidity

Research output: Working paperOther research output

Abstract

Recent empirical work documents large liquidity risk premiums in stock markets. We calculate the liquidity risk premiums demanded by large investors by solving a dynamic portfolio choice problem with stochastic price impact of trading, CRRA utility and a time-varying investment opportunity set. We find that, even with high trading-cost rates and substantial trading motives, the theoretically demanded liquidity risk premium is negligible, less than 3 basis points per year. Assuming forced selling during market downturn enlarges the liquidity risk premium to maximally 20 basis points per year, which is well below existing empirical estimates of the liquidity risk premium.
Original languageEnglish
Place of PublicationTilburg
PublisherNETSPAR
Number of pages53
DOIs
Publication statusPublished - Jan 2016

Publication series

NameNetspar Discussion Paper
Volume12/2015-049

Fingerprint

Dynamic portfolio choice
Liquidity risk
Risk premium
Illiquidity
Price impact
Investment opportunity set
Trading costs
Investors
Time-varying
Stock market

Keywords

  • liquidity premium
  • liquidity risk
  • dynamic portfolio choice
  • trading costs
  • price impact

Cite this

Driessen, Joost ; Xing, R. / Who Is Afraid of Liquidity Risk? Dynamic Portfolio Choice with Stochastic Illiquidity. Tilburg : NETSPAR, 2016. (Netspar Discussion Paper).
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Who Is Afraid of Liquidity Risk? Dynamic Portfolio Choice with Stochastic Illiquidity. / Driessen, Joost; Xing, R.

Tilburg : NETSPAR, 2016. (Netspar Discussion Paper; Vol. 12/2015-049).

Research output: Working paperOther research output

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