In conventional asset pricing models, the required rate of
returnforanassetisafunctionofitsexposuretomarketrisk.
Thus,inthecapitalassetpricingmodel(CAPM)thecostof
equityisafunction ofthebetaofan asset,whereasin the
arbitragepricingmodel(APM)ormultifactormodelthecost
ofequityisdetermined bytheasset’s exposureto multiple
sourcesof market risk.There islittlein thesemodels that
allows for illiquidity. Consequently, the required rate of
returnwill be the samefor liquid and illiquidassets with
similarmarketriskexposure.Inrecentyears,therehavebeen
attemptstoexpandthesemodelstoallowforilliquidityriskin
one of two ways.Thefirst way is theoreticalmodels that
buildinamarketpremiumforilliquiditythataffectsallassets
andmeasuresofilliquidityforindividualassets.Differences
inthelatterwillcauserequiredratesofreturntovaryacross
companies with different degreesof liquidity.The second
way ispurelyempirical multifactor modelsthat attemptto
explain differences in returnsacross stocksover long time
periods,withameasureofilliquiditysuchastradingvolume
or the bid-ask spread considered one of the factors.
Theearliesttheoreticaldiscussionsofhowbesttoincorporate
illiquidity intoasset pricingmodelsoccurred in the1970s.
Mayers(1972,1973,1976)extendedthecapitalassetpricing
model to consider nontraded assets as well as human capital.
23 Theresultingmodelsdidnotmakeexplicitadjustmentsfor
illiquidity, though. Ina morerecent attemptto incorporate
illiquidityintoexpectedreturnmodels,AcharyaandPedersen
(2005)examinehowassetsarepricedwithliquidityriskand
makeacriticalpoint:Itisnotjusthowilliquidanassetisthat
matters butwhenit is illiquid.
24 Inparticular,anassetthatisilliquidwhenthemarketitself
isilliquid(whichusuallycoincideswithdownmarketsand