The capital asset pricing model and the liquidity effect: A theoretical approach

In this paper we develop a CAPM-based model which incorporate liquidity costs. This model implies, that for markets with nontrivial liquidity costs, the measure of systematic risk is based on returns net of bid-ask spread. Another implications of our CAPM-based model is that the relationship between the expected return and the bid-ask spread is positive and convex. This results differs from Amihud and Mendelson's (1986) concave relationship, but is consistent with empirical evidence obtained by Brennan and Subrahmanyam (1996).

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