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 either wait until at a favorable price or implement the bid ask price at once (Liu 2006).
2.2 Liquidity measures
Liquidity can be divided into four dimensions: trading quantity, trading speed, trading cost and price impact (Liu, 2006). While the transaction costs could reduce the return on investment, the reasonable investors will need to reduce the expected costs using bid-ask spread method (Liu 2006). Furthermore, the unexpected fluctuations in the financial market could cause the liquidity risk (Liu 2006). In the essay, the transaction costs would be more focused.
2.3 The relationship of liquidity and asset pricing
According to Baks and Kramer (1999), liquidity could increase the inflation in asset price, which leads to the increase in the fixed supply. Moreover, the increase in liquidity could rise in asset prices (Baks and Kramer, 1999). Furthermore, the decrease in interest rate could increase the demand and imply higher future dividends, which lead to an increase in stock (Baks and Kramer, 1999).
2.3.1 Bid-Ask Spread
Based on the conception of Amihud and Mendelson (1986), the bid-ask spread is a measurement to evaluate liquidity, which reveals the relationship between expected return and bid-ask...