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Journal of Finance Vol. 62 No. 5 2007

Liquidity Premia and Transaction Costs

Bong-Gyu Jang1; HYENG KEUN KOO; Hong Liu2; Mark Loewenstein3,4,5

1 Korea Advanced Institute of Science and Technology · 2 Washington University in St. Louis · 3 American University · 4 University of Illinois Chicago · 5 University of Maryland, College Park

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.

DOI
10.1111/j.1540-6261.2007.01277.x
Volume
62
Issue
5
Pages
2329-2366
Language
en
Sources
bibtex:phds-export.bib openalex crossref

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