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Flight to quality, flight to liquidity, and the pricing of risk

Vayanos, Dimitri (2004) Flight to quality, flight to liquidity, and the pricing of risk. NBER Working Papers (10327). National Bureau of Economic Research, Inc, London, UK.

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We propose a dynamic equilibrium model of a multi-asset market with stochastic volatility and transaction costs. Our key assumption is that investors are fund managers, subject to withdrawals when fund performance falls below a threshold. This generates a preference for liquidity that is time-varying and increasing with volatility. We show that during volatile times, assets' liquidity premia increase, investors become more risk averse, assets become more negatively correlated with volatility, assets' pairwise correlations can increase, and illiquid assets' market betas increase. Moreover, an unconditional CAPM can understate the risk of illiquid assets because these assets become riskier when investors are the most risk averse.

Item Type: Monograph (Working Paper)
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Additional Information: Published 2004 © Dimitri Vayanos. LSE has developed LSE Research Online so that users may access research output of the School. Copyright © and Moral Rights for the papers on this site are retained by the individual authors and/or other copyright owners. Users may download and/or print one copy of any article(s) in LSE Research Online to facilitate their private study or for non-commercial research. You may not engage in further distribution of the material or use it for any profit-making activities or any commercial gain. You may freely distribute the URL ( of the LSE Research Online website.
Divisions: LSE
Subjects: H Social Sciences > HG Finance
Date Deposited: 10 Nov 2005
Last Modified: 21 Jan 2021 00:44

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