In this paper, we extend the Epstein and Zin (1989, 1991) model with liquidity risk and assess the extended model's performance against the traditional consumption pricing models. We show that liquidity is a significant risk factor, and it adds considerable explanatory power to the model. The liquidity-extended model produces both a higher cross-sectional R2 and a smaller Hansen and Jagannathan (1997) distance than the traditional consumption-based capital asset pricing model (CCAPM) and the original Epstein-Zin model. Overall, we show that liquidity is both a priced factor and a key contributor to the extended Epstein-Zin model's goodness-of-fit.
Published in
Financial ReviewVolume
51Issue
1Pages
113 - 146Citation
LIU, W., LUO, D. and ZHAO, H., 2016. The Epstein-Zin model with liquidity extension. Financial Review, 51(1), pp. 113-146.Publisher
© The Eastern Finance Association. Published by WileyVersion
AM (Accepted Manuscript)Publisher statement
This work is made available according to the conditions of the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International (CC BY-NC-ND 4.0) licence. Full details of this licence are available at: https://creativecommons.org/licenses/by-nc-nd/4.0/Publication date
2016-01-12Notes
This is the peer reviewed version of the following article: LIU, W., LUO, D. and ZHAO, H., 2016. The Epstein-Zin model with liquidity extension. Financial Review, 51(1), pp. 113-146, which has been published in final form at http://dx.doi.org/10.1111/fire.12098. This article may be used for non-commercial purposes in accordance with Wiley Terms and Conditions for Self-Archiving.ISSN
0732-8516Language
en
CC BY-NC-ND 4.0