Liquidity Premia and Transaction Costs

Bong-Gyu Jang, Hyeng Keun Koo, Hong Liu and Mark Loewenstein

Journal of Finance, 2007, vol. 62, issue 5, pages 2329-2366

Abstract: Standard literature concludes that transaction costs only have a "second-order" effect on liquidity premia. We show that this conclusion depends crucially on the assumption of a constant investment opportunity set. In a regime-switching model in which the investment opportunity set varies over time, we explicitly characterize the optimal consumption and investment strategy. In contrast to the standard literature, we find that transaction costs can have a "first-order" effect on liquidity premia. However, with reasonably calibrated parameters, the presence of transaction costs still cannot fully explain the equity premium puzzle. Copyright 2007 by The American Finance Association.

Date: 2007
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