Starting with the capital asset pricing model (CAPM, derived by Sharpe 1964, Lintner 1965 and Mossin 1966), market finance has emphasized the role of consumers’ time preference and risk aversion in the determination of asset prices. The intertemporal consumption-based asset pricing model (e.g., Rubinstein 1976, Lucas 1978, Breeden 1979, Harrison-Kreps 1979, Cox et al. 1985, Hansen-Jagannathan 1991) predicts that an asset’s current price is equal to the expectation, conditioned on current information, of the product of the asset’s payoff and a representative consumer’s intertemporal marginal rate of substitution (IMRS). While fundamental, this dominant paradigm for pricing assets has some well-recognized shortcomings (see below), and there is clearly scope for alternative and complementary approaches. This paper begins developing one such approach based on aggregate liquidity considerations.

Our starting point is that the productive and financial spheres of the economy have autonomous demands for financial assets and that their valuations for these assets are often disconnected from the representative consumer’s. Corporate demand for financial assets is driven by the desire to hoard liquidity in order to fulfill future cash needs. In contrast to the logic of traditional asset pricing models based on perfect markets, corporations are unable to raise funds on the capital market up to the level of their expected income, and hence the corporate sector will use financial assets as a cushion against liquidity shocks (Holmstrom-Tirole, 1996, 1998). Financial assets that can serve as cushions will command liquidity premia.

There is substantial evidence that firms and banks hold liquid assets as a partial or full guarantee of future credit availability (see, e.g., Crane 1973 and Harrington 1987). Companies protect themselves against future credit rationing by holding securities and, especially, by securing credit lines and loan commitments with banks and other financial institutions. Lines of credit cover working capital needs and back up commercial paper sales. Commitments provide longterm insurance through revolving credits, which often have an option that allows the company to convert the credit into a term loan at maturity, and through back-up facilities that protect a firm against the risk of being unable to roll over its outstanding commercial paper. Companies pay a price for these insurance services through upfront commitment fees and costly requirements to maintain compensatory balances.

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