Valuing a Liquidity Discount

Abstract

In the recent financial crisis, unprecedented compressions of securities prices were frequently observed. Such compressions were mainly driven by the lack of liquidity. We therefore propose an equilibrium model for quantifying such liquidity compressions in prices. We demonstrate that our model can produce extremely large discounts while there are no substantial changes in economic fundamentals and under very reasonable levels of risk preference. Furthermore, our model can be extended to explain high correlations among assets observed in a crisis and to include Merton-type default models to provide interactions between liquidity and credit risks. Such an implication helps further the construction of models for stress tests and risk management.