costs,thuscreatingadiscountonvalue. Inthesecond, the
requiredrateofreturnon anasset isadjustedtoreflectits
illiquidity, with higher required rates ofreturn (and lower
values)forlessliquidassets.Inthethird,thelossofliquidity
isvaluedasanoption,wheretheholderoftheilliquidassetis
assumedtolosetheoptiontoselltheassetwhenithasahigh
price.Allthreearriveattheconclusionthatanilliquidasset
shouldtradeatalowerpricethananotherwisesimilarliquid
asset.
Illiquidity Discount on Value
Assume that you arean investor trying to determine how
much you should pay for an asset. In making this
determination,youhavetoconsiderthecashflowsthatthe
assetwillgenerateforyouandhowriskythesecashflowsare
toarriveatanestimateofintrinsicvalue.Youwillalsohave
toconsiderhowmuchitwillcostyoutosellthisassetwhen
youdecidetodivestitinthefuture.Infact,iftheinvestor
buyingitfromyoubuildsinasimilarestimateoftransactions
cost shewillfacewhen shesells it,thevalueoftheasset
today should reflect the expected value of all future
transactionscosttoallfutureholdersoftheasset.Thisisthe
argument thatAmihudand Mendelsonused in1986, when
theysuggested thatthepriceof anasset would embedthe
present value of the costs associated with expected
transactions costs in the future.
19 Intheirmodel,thebid-askspreadisusedasthemeasureof
transactionscostsand evensmallspreadscantranslateinto
big illiquidity discounts on value. The magnitude of the
discountwillbe afunctionofinvestorholdingperiodsand
turnover ratios, with shorter holding periods and higher
turnover associated with biggerdiscounts. Vayanos (1998)