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.
- Consumption-based asset pricing
- Liquidity risk
- Model performance
ASJC Scopus subject areas
- Economics and Econometrics