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1 June 2016 CFA Institute Journal Review

Transaction Costs, Liquidity Risk, and the CCAPM (Digest Summary)

  1. Paul Lebo

Using empirical evidence, the authors demonstrate that liquidity serves an important function in investors’ decision-making processes. In fact, the traditional consumption-based capital asset pricing model (CCAPM) can and should be modified to include the effect of liquidity. To this end, the authors unveil their liquidity-adjusted CCAPM and show that it has 79% additional explanatory power compared with the traditional CCAPM.

What’s Inside?

Previous research surrounding the CAPM has dealt with the impact of consumption, describing a connection between the CAPM and the ability of individuals to consume goods and services. With this new and groundbreaking research, the authors show that both consumption and liquidity affect investors’ decisions. Therefore, both consumption and liquidity should be taken into account. By leveraging different measures to track the impact of transaction costs, the authors explain a greater fraction of the variations in expected returns than is explained by the traditional consumption-based capital asset pricing model (CCAPM).

The authors’ model incorporates transaction costs into the CCAPM. The specific transaction cost is time varied, suggesting that the investor faces uncertain future costs of trading. Specifically, the investor can buy a stock at a given price but must subtract the transaction cost upon sale of the stock. This method of recognizing transaction costs is consistent with the research of Acharya and Pedersen (Journal of Financial Economics 2005).

How Is This Research Useful to Practitioners?

The CAPM is the cornerstone of many areas of finance, from equity research to business valuations. In the equity research setting, the CAPM helps determine the appropriate cost of equity, which is used in the weighted average cost of capital (WACC) equation to determine whether a stock is under- or overvalued. In a business valuation setting, the CAPM helps determine the cost of equity used in the WACC, which is then used in the process of allocating the purchase price to the different assets on the balance sheet. In both settings, the CAPM provides a foundational element to valuation; experts rely on it extensively.

By introducing a new, enhanced version of the CCAPM, the authors uncover a potentially more accurate and complete rendering of this widely respected and accepted model.

How Did the Authors Conduct This Research?

The authors produce a model that shows that the expected return of a stock is positively correlated with its expected transaction costs. They include consumption growth in their model, consistent with the CCAPM, to demonstrate that stocks with higher consumption risk demand a higher risk premium. Finally, they add the liquidity risk component to the equation, which is essentially the negative covariance between a stock’s transaction costs and consumption growth. In this manner, a high degree of liquidity risk would be associated with a situation in which transaction costs increase when consumption growth falls.

In the derivation of their liquidity-adjusted CCAPM, the authors empirically test their model using two proxies for transaction costs: effective trading costs and the bid–ask spread estimates. They use several additional proxies for capturing the liquidity—namely, (1) the negative dollar volume measure, (2) the price impact measure, and (3) a trading discontinuity measure. With a sample that extends from 1950 to 2009, the authors run empirical studies and find that their liquidity-adjusted CCAPM has 79% additional explanatory power compared with the traditional CCAPM.

Abstractor’s Viewpoint

The authors unveil a newly formulated liquidity-adjusted CCAPM that provides an arguably more comprehensive approach to determining the cost of equity than previous models. The research provides compelling evidence to support the explanatory power of the model. This article is essential reading for anyone who works in an investment decision-making capacity.

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