Pricing of time-varying illiquidity within the Eurozone

Evidence using a Markov switching liquidity-adjusted capital asset pricing model

Stefano Grillini, Aydin Ozkan, Abhijit Sharma, Mazin Al Janabi

Research output: Contribution to journalArticle

Abstract

This paper investigates time-varying characteristics of illiquidity and the pricing of its risk using a liquidity-adjusted capital asset pricing model (L-CAPM). Collecting data from a pool of Eurozone countries between 1990 and 2018, we employ Markov switching models to assess the degree of persistence of illiquidity shocks. Contrary to prior research, which largely makes use of autoregressive (AR) processes, we provide strong evidence that illiquidity is time-varying and the persistence of shocks determines two distinct regimes characterised by high and low illiquidity. We assess pricing of illiquidity risk by developing and empirically testing a conditional L-CAPM model, where different regimes constitute priced risk factors for the cross-section of stock returns. We extend previous unconditional versions of L-CAPM models and we show that the various channels through which illiquidity affects asset returns and price of risks are time-varying. We find strong support for our conditional L-CAPM and our results are robust to alternative specifications and estimation techniques. These findings have important implications for portfolio management practices and are relevant to portfolio and risk managers and regulatory institutions.
Original languageEnglish
Pages (from-to)145-158
Number of pages14
JournalInternational Review of Financial Analysis
Volume64
Early online date17 May 2019
DOIs
Publication statusPublished - Jul 2019

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Time-varying
Markov switching
Euro zone
Illiquidity
Pricing
Capital asset pricing model
Liquidity
Persistence
Testing
Autoregressive process
Markov switching model
Management practices
Cross-section of stock returns
Price of risk
Asset prices
Managers
Asset returns
Risk factors
Portfolio management

Cite this

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title = "Pricing of time-varying illiquidity within the Eurozone: Evidence using a Markov switching liquidity-adjusted capital asset pricing model",
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Pricing of time-varying illiquidity within the Eurozone : Evidence using a Markov switching liquidity-adjusted capital asset pricing model. / Grillini, Stefano; Ozkan, Aydin; Sharma, Abhijit; Al Janabi, Mazin.

In: International Review of Financial Analysis, Vol. 64, 07.2019, p. 145-158.

Research output: Contribution to journalArticle

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