Pricing liquidity risk with heterogeneous investment horizons, working paper Cass Business School

We develop a liquidity-based asset pricing model featuring investors with het-erogeneous investment horizons and stochastic transaction costs. In an equilibrium where all investors invest in all assets (integration), we find that the existence of investors with heterogeneous horizons, as opposed to homogeneous horizons, re-duces the importance of liquidity risk relative to the standard CAPM market risk and generates a more complex effect of expected liquidity. In an equilibrium where short-term investors do not invest in some more illiquid assets (partial segmenta-tion), our model generates an additional segmentation premium for these assets. We estimate the model for the cross-section of U.S. stocks using GMM and find that our heterogeneous-horizon asset pricing model fares better than a standard liquidity-adjusted CAPM. The segmented version of our model delivers the best cross-sectional fit and generates a substantial effect of expected liquidity on ex-pected returns