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Asset prices in general equilibrium with recursive utility and illiquidity induced by transactions costs

Adrian Buss, Raman Uppal and Grigory Vilkov ()

No 41, SAFE Working Paper Series from Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt

Abstract: In this paper, we study the effect of proportional transaction costs on consumption-portfolio decisions and asset prices in a dynamic general equilibrium economy with a financial market that has a single-period bond and two risky stocks, one of which incurs the transaction cost. Our model has multiple investors with stochastic labor income, heterogeneous beliefs, and heterogeneous Epstein-Zin-Weil utility functions. The transaction cost gives rise to endogenous variations in liquidity. We show how equilibrium in this incomplete-markets economy can be characterized and solved for in a recursive fashion. We have three main findings. One, costs for trading a stock lead to a substantial reduction in the trading volume of that stock, but have only a small effect on the trading volume of the other stock and the bond. Two, even in the presence of stochastic labor income and heterogeneous beliefs, transaction costs have only a small effect on the consumption decisions of investors, and hence, on equity risk premia and the liquidity premium. Three, the effects of transaction costs on quantities such as the liquidity premium are overestimated in partial equilibrium relative to general equilibrium.

Keywords: liquidity premium; incomplete markets; portfolio choice; heterogeneous agents (search for similar items in EconPapers)
JEL-codes: G11 G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge, nep-ore and nep-upt
Date: 2014
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (9) Track citations by RSS feed

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