Stock returns with consumption and illiquidity risks

This paper derives closed-form expressions for consumption-based stochastic discount factors adjusted by market-wide illiquidity shocks, considering both contemporaneous and ultimate consumption risk. We find that market-wide illiquidity risk is important for pricing risky assets under alternative preference specifications, although it is especially relevant when we allow for ultimate consumption risk. We also find a large and highly significant illiquidity risk premium for the first quarter of the year suggesting a time-varying behavior of the market-wide illiquidity premium.