Labor Income Risk, Consumption Risk, and Liquidity Premium in the Long Run

We study the risk exposure of liquidity portfolios to labor income and consumption risk in the long run using a dynamic general equilibrium model that features flexible labor-leisure choice and recursive utility. We find that investors are willing to pay price premium for liquid stocks because these stocks provide a good hedge against labor income risk and long-run risk. With moderate risk aversion, the model-implied long-run liquidity premium matches the observed liquidity premium of 5.67% per annum, with about 70% attributed to compensation for labor income risk and 30% to consumption risk in the long run