The Liquidity-Adjusted CAPM

The standard CAPM says an asset's expected return depends only on its covariance with the overall market's return — its beta. It quietly assumes trading is frictionless, which is never quite true: every trade costs something in spread and price impact, and that cost itself varies with market conditions. Acharya and Pedersen's liquidity-adjusted CAPM builds those trading costs directly into the pricing model, and in doing so uncovers a second, subtler risk: an asset's liquidity tends to dry up precisely when the whole market's liquidity dries up, and investors demand compensation for holding assets that become hardest to sell exactly when selling matters most.

The model decomposes required return into the ordinary market-beta compensation plus a net liquidity effect made of three separate covariance terms: the covariance of the asset's own illiquidity with market illiquidity (the "flight to liquidity" risk), the covariance of the asset's return with market illiquidity, and the covariance of the asset's illiquidity with market return. Put in plain English, holding an asset that becomes especially illiquid whenever the whole market seizes up — as during a crisis — is riskier than a standard beta calculation alone would suggest, so investors need to be paid extra expected return to hold it.

For instance, two stocks with identical market betas might trade at different expected returns if one's bid-ask spread reliably blows out during broad market stress while the other's stays stable — the model attributes that gap to priced liquidity risk rather than treating it as an anomaly.