ASSET PRICING MODEL: Introduction 4


For instance, unlike the consumption CAPM, our model implies that an increase in the supply of liquidity drives bond prices down at the same time as stock prices go up. In empirical work, we also believe that the corporate sector may offer a better measure of changes in the marginal purchaser’s IMRS than do corresponding attempts to study partial participation among consumers. (For a recent effort, see Vissing-Jorgensen, 1997).

Third, in our model the yield curve is determined by the value of various maturities as liquidity buffers, and is also affected by the availability of other assets and by the anticipated institutional liquidity needs. This generates richer patterns for the yield curve than in a consumption-based theory.

Fourth, in our model price volatility is state contingent and exhibits serial correlation. Under some conditions, the price volatility of fixed-income securities covaries negatively with the price level (as Black 1976 notes, volatilities, which covary across assets, go up when stock prices go down.) Intuitively, fixed-income securities embody an option-like liquidity service. When there is a high probability of a liquidity shortage, the option is “in the money” and its price will be sensitive to news about the future. When the probability of liquidity shortage is sufficiently low, the price of the option goes to zero and will not respond much to news.

The paper is organized as follows. Section 2 illustrates the determination of liquidity premia through a simple example. Section 3 sets up a general model of corporate liquidity demand. This model shows how departures from the Arrow-Debreu paradigm generates liquidity premia. Sections 4 and 5 demonstrate that the liquidity approach delivers interesting insights for the volatility of asset prices and for the yield curve. The final section 6 studies two examples with endogenous date-1 asset prices to illustrate the possibility of multiple equilibria and the role that policy measures can play in ensuring that the better equilibrium gets selected. The first example (section 6.1) suggests that unemployment insurance can provide liquidity that supports long-term investments. The second example (section 6.2) illustrates the problem with real assets as sources of liquidity: such assets have a low value precisely when the aggregate need for liquidity is high.

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