The Epstein–Zin Model with Liquidity Extension

Abstract

In this paper, we extend the Epstein–Zin 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 distance than the traditional consumption‐based capital‐asset pricing model 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.

Asset pricing and energy consumption risk

“…Regarding international evidence, the standard world CCAPM has also been extended to consider world habit models, cross-country consumption heterogeneity, incomplete markets, etc. The conventional consumption risk models have been extended to incorporate other risks such as inflation (Shi et al, 2017) and liquidity (Liu et al, 2016). For comprehensive reviews of consumption-based asset pricing in general, see Campbell (2003), Mehra (2012), Ludvigson (2013) and Breeden et al (2015).…”