Liquidity might come at cost: The role of heterogeneous preferences

Asset-pricing models with volume are challenged by the high turnover-rates in real stock markets. We develop an asset-pricing framework with heterogeneous risk preferences and show that liquidity and turnover increase with heterogeneity to a maximum, and then decline. With U.S. parameters, turnover...

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Bibliographic Details
Published in:Journal of financial markets (Amsterdam, Netherlands) Netherlands), 2018-06, Vol.39, p.1-23
Main Authors: Hauser, Shmuel, Kedar-Levy, Haim
Format: Article
Language:English
Subjects:
Discount rate risk
Heterogeneity
Liquidity
Sharpe ratio
Turnover
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Summary:Asset-pricing models with volume are challenged by the high turnover-rates in real stock markets. We develop an asset-pricing framework with heterogeneous risk preferences and show that liquidity and turnover increase with heterogeneity to a maximum, and then decline. With U.S. parameters, turnover exceeds 55%. Liquidity is costly since it facilitates a large share redistribution across agents, causing changes in average risk aversion, which increases Sharpe ratio variability, and hence stock return volatility. Illiquidity and its risk are minimized at moderate heterogeneity levels, highlighting an "optimal" heterogeneity level, yet, there is no "optimal" combination between liquidity level and Sharpe ratio variability. •Heterogeneous risk preferences indeed generate trade, but not monotonically.•Turnover and liquidity increase with heterogeneity to a maximum and then decline.•Higher liquidity increases share-redistribution and hence average RRA volatility.•Thus, liquidity is costly, as it increases Sharpe ratio and stock price volatility.•The model generates turnover levels comparable to real data, at reasonable RRAs.
ISSN:1386-4181
1878-576X
DOI:10.1016/j.finmar.2018.03.001