Adjusting for Illiquidity
Conceptually, illiquidity is difficult to compensate. Getmansky, Lo, and Makarov demonstrate that illiquidity causes serial correlation in observed returns due to stale pricing. The degree of illiquidity can be modeled as the proportion ρ of the previous period's return that is carried forward to the current return:
The variance of this return is:
A model of liquidity-modified leveraged risk is therefore:
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