Stock Liquidity Premium With Stochastic Price Impact and Exogeous Trading Strategy

This paper provides a model which helps explain the variability of stock liquidity premium. I model liquidity as a time-varying price impact and include both permanent as well as temporary price impact. Liquidity premium is defined as an additional return that stock should yield to compensate an investor for the loss of wealth utility caused by price impact costs. I find that liquidity premium varies with the expected net stock return, return volatility and, to a lesser extent, with the returns on risk-free bonds. I also conclude that the liquidity premium arises mainly as a result of the effect of temporary price impact. The “Per unit liquidity premium” associated with temporary price impact is more than 2 times higher than that associated with the permanent one