in that all trades involve some transaction cost. Investors prefer more liq- uid assets with lower transaction costs, so it should not surprise us to find that all else equal, relatively illiquid assets trade at lower prices or, equivalently, that the expected re- turn on illiquid assets must be higher. Therefore, an illiquidity premium must be im- pounded into the price of each asset. We start with the simplest case, in which we ignore systematic risk. Imagine a world with a large number of uncorrelated securities. Because the securities are uncorrelated, well-diversified portfolios of these securities will have standard deviations near zero and III. Equilibrium In Capital Markets 9. The Capital Asset Pricing Model The McGraw−Hill Companies, 2001           CHAPTER 9 The Capital Asset Pricing Model 281     the market portfolio will be virtually as safe as the risk-free asset. In this case, the market risk premium will be zero. Therefore, despite the fact that the beta of each security is 1.0, the expected rate of return on all securities will equal the risk-free rate, which we will take to be the T-bill rate. Assume that investors know in advance for how long they intend to hold their portfo- lios, and suppose that there are n types of investors, grouped by investment horizon. Type 1 investors intend to liquidate their portfolios in one period, Type 2 investors in two peri- ods, and so on, until the longest-horizon investors (Type n) intend to hold their portfolios for n periods. We assume that there are only two classes of securities: liquid and illiquid. The liquida- tion cost of a class L (more liquid) stock to an investor with a horizon of h years (a Type h investor) will reduce the per-period rate of return by cL/h%. For example, if the combina- tion of commissions and the bid-asked spread on a security resulted in a liquidation cost of 10%, then the per-period rate of return for an investor who holds stock for five years would be reduced by approximately 2% per year, whereas the return on a 10-year investment would fall by only 1% per year.18 Class I (illiquid) assets have higher liquidation costs that reduce the per-period return by cI/h%, where cI is greater than cL. Therefore, if you intend to hold a class L security for h periods, your expected rate of return net of transaction costs is E(rL) cL/h. There is no liquidation cost on T-bills. The following table presents the expected return investors would realize from the risk- free asset and class L and class I stock portfolios assuming that the simple