A novel measure of liquidity premium: application to the Korean stock market

ABSTRACT

This study proposes a novel measure for an asset’s liquidity premium. Applying Brownian first-passage time distribution properties, we derive an explicit form of liquidity premium embedded in the asset price. Our liquidity premium measure is intuitive because it assesses the extent to which the value of the asset should be increased from the current market price if investors were allowed to retain the asset until they achieve an investment goal. This measure is readily available for assessing an asset’s liquidity because it does not require information on the asset’s transactional characteristics. Our empirical experiment using Korean stock market data suggests that the liquidity premium in this study is inversely related to Amihud’s (2002) illiquidity ratio, which is commonly used to measure stocks’ illiquidity.

KEYWORDS:

• Liquidity premium
• first-passage time distribution
• locked-in strategies
• Amihud’s illiquidity ratio

JEL CLASSIFICATION:

• G11
• G12

Acknowledgements

We would like to thank the anonymous referee for the helpful comments. Both the authors have equally contributed to this study.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ For example, Korajczyk and Sadka (2008), among others, consider Amihud’s (2002) illiquidity ratio as one of the measures to capture the latent factor of stock liquidity. In particular, Bekaert, Harvey, and Lundblad (2007) examine the impact of stock liquidity on expected returns in emerging financial markets while proposing a new measure of liquidity. Further, they compare the proposed measure to Amihud’s illiquidity ratio to validate the measure. In addition, Hur and Chung (2017) use Amihud’s illiquidity ratio as a proxy variable to measure the degree of stock illiquidity in the Korean stock market and consider that the characteristics of stocks with high Amihud’s illiquidity ratio could be akin to those of non-traded stocks.

² The liquidity premium and discount have the same magnitude but opposite signs.

³ Our empirical results are not sensitive to the choice of the time-discount factor and relative-risk aversion. Although the results have not been reported for brevity, they are available upon request.