Liquidity is one of the most basic features in financial markets. It is a vital elements leading to constant and effective financial markets (Huang and Wang 2009). However, if short of liquidity could cause financial crisis even collapses in the global financial markets. For example, in 1987, the lack of liquidity caused the stock market blow and there was a great change in the credit market since the Long Term Capital Management (LTCM) almost collapsed in 1998 (Huang and Wang 2009). As a result, liquidity is a great importance element to stabilize financial markets and set the asset price.
For a deficiency of Liquidity is also regarded as one of the risks in the market. the risk comes from relative slow trade so that people do not have enough money to meet the demand for depositors or investors. There is a hot debate that how liquidity could affect the asset prices in the financial area. Therefore, the analyses about how liquidity affects asset prices are come out.
In this essay, the role of liquidity, price setting, relationship between liquidity and asset pricing with liquidity measures of the Amihud and Mendelson Model based on bid-ask spread, the traditional model capital asset pricing model (CAMP) and the new model ILLIQ will be illustrated and explored based on certain of examples from stock market in China and empirical data.
2.0 Liquidity and Asset pricing
2.1 Concept of liquidity
Liu (2006) states that liquidity can be described as the ability to sell and buy abundant numbers of assets rapidly at low cost and with little price influence. According to Amihud and Mendelson (1986), illiquidity can be measured by the cost of immediate execution, which means the person who wants to transact could e...
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...-ask spread model, CAPM model, and the ILLIQ model to fully illustrate how liquidity affects the asset pricing. With respect to the models from Amihud and Mendelson (1986), the more liquid trade is, the higher prices are sold. Besides, liquidity and asset prices are negatively related.
The implement of CAPM, the Chinese stock market is demonstrated as an example to evaluate. However, due to the reality of the world economy and country’s political issue, the conclusion is proved to be ineffective (Wu, 2006). For the purpose of enhancing the market liquidity, people in the financial market need to compensate the trading costs, such as transaction costs, which helps lower prices and gets the higher expected returns (Ding etal 2013). To improve the quality of firms, augmenting the capability of management, improving market structure should be emphasized on (Wu, 2006).
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