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.
History
School
Business and Economics
Department
Business
Published in
Financial Review
Volume
51
Issue
1
Pages
113 - 146
Citation
LIU, W., LUO, D. and ZHAO, H., 2016. The Epstein-Zin model with liquidity extension. Financial Review, 51(1), pp. 113-146.
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
2016-01-12
Notes
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.