LAUSR

Abstract This paper provides a model which helps explain the variability of stock liquidity premium. Liquidity is modelled as a time-varying price impact and includes both permanent as well as temporary price impacts. Liquidity premium is defined as an additional expected return that stock should yield to compensate an investor for the potential loss of wealth utility caused by price impact costs. The numerical results presented show that liquidity premium varies with expected net stock return, return volatility and, to a lesser extent, with returns on risk-free bonds. Liquidity premium is a growing and convex function of liquidity costs, and temporary price impact has a more severe effect on liquidity premium than the permanent one.