The Liquidity Component of the Equity Premium
Australian School of Business at UNSW
Peter L. Swan
University of New South Wales (UNSW); Financial Research Network (FIRN)
February 21, 2008
Second Singapore International Conference on Finance 2008
Adding a motivation for trading due to endowment differences to standard asset pricing assumptions, we investigate the impact of illiquidity due to small numbers of participants. We calibrate to observed activity levels, returns, transaction costs and volatility in equity markets. We show that, while the price of an illiquid asset is itself unaffected by its illiquidity, with the introduction of an equivalent liquid asset, which trades at a premium, we nonetheless replicate the findings of Mehra and Prescott (1985). The required transactional charges are modest in some calibrations. We show that the major part of the equity premium can be explained as a liquidity premium.
Number of Pages in PDF File: 36
Keywords: equity-premium puzzle, asset prices, liquidity, trading, transaction cost
JEL Classification: G12, G11, G310, C61, D91, D92working papers series
Date posted: March 23, 2007 ; Last revised: April 6, 2008
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