Becker Friedman Institute
for Research in Economics
The University of Chicago

Research. Insights. Impact. Advancing the Legacy of Chicago Economics.

Random Risk Aversion and Liquidity: a Model of Asset Pricing and Trade Volumes

September 2016
Fernando Alvarez and Andy Atkeson

Grossman, Campbell, and Wang (1993) present evidence that measures of trading volume are important factors in accounting for the serial correlation in returns for stock indices and individual large stocks while and Pastor and Stambaugh (2003) present evidence that the covariance of individual stock returns with a proxy for aggregate liquidity based on a measure of trading volume and the serial correlation of returns is an important factor in accounting for the cross section of individual stock returns. We present a tractable theoretical model that accounts for these observations. In the model, agents experience idiosyncratic shocks to risk aversion and/or beliefs and these shocks drive both trading volume and asset returns. These shocks drive alter the serial correlation of returns since a shock that increases the risk aversion of the average investor results in a drop in stock prices on impact, followed by an increase in expected returns. Dispersion of the idiosyncratic shocks to risk aversion and/or beliefs result in trade and investors regard these shocks as a risk. Just as is the case in the models of asset pricing with idiosyncratic shocks to income studied by Mankiw (1986) and Constantinedes and Due (1996), covariance between shocks to the risk aversion of the average investor and to the dispersion of idiosyncratic shocks to risk aversion result in these risks being priced in the cross-section of asset returns. Intuitively, each investor is concerned about the risk that he or she will want to sell risky assets at a time in which the price for such assets is low if he or she experiences a higher-than-average shock to risk aversion at the same time that the risk aversion of the average investor is high. In this way, our model delivers a simple theoretical foundation for the motivating facts regarding trading volume and asset pricing. We also study the impact of taxes on trading on welfare in this environment and show that such taxes have a first-order negative impact on ex-ante welfare.