Liquidity Premia in Dynamic Bargaining Markets

Abstract

This paper develops a search-theoretic model of the cross-sectional distribution of asset returns, abstracting from risk premia and focusing exclusively on liquidity. I derive a float-adjusted return model (FARM),explaining the pricing of liquidity with a simple linear formula: In equilibrium, the liquidity spread of an asset is proportional to the inverse of its free float, the portion of its market capitalization available for sale. This suggests that the free float is an appropriate measure of liquidity, consistent with the linear specifications commonly estimated in the empirical literature.The qualitative predictions of the model corroborate much of the empirical evidence.