Asset Prices in General Equilibrium with Recursive Utility and Illiquidity Induced by Transactions Costs

46 Pages Posted: 12 Dec 2013 Last revised: 11 Jan 2019

See all articles by Adrian Buss

Adrian Buss

Frankfurt School of Finance & Management; Centre for Economic Policy Research (CEPR)

Raman Uppal

EDHEC Business School; Centre for Economic Policy Research (CEPR)

Grigory Vilkov

Frankfurt School of Finance & Management

Multiple version iconThere are 2 versions of this paper

Date Written: February 18, 2015

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 two 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.

Keywords: Liquidity premium, incomplete markets, portfolio choice, heterogeneous agents, general equilibrium

JEL Classification: G11, G12

Suggested Citation

Buss, Adrian and Uppal, Raman and Vilkov, Grigory, Asset Prices in General Equilibrium with Recursive Utility and Illiquidity Induced by Transactions Costs (February 18, 2015). INSEAD Working Paper No. 2014/01/FIN, Available at SSRN: https://ssrn.com/abstract=2366296 or http://dx.doi.org/10.2139/ssrn.2366296

Adrian Buss

Frankfurt School of Finance & Management ( email )

Adickesallee 32-34
Frankfurt, 60322
Germany

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Raman Uppal

EDHEC Business School ( email )

58 rue du Port
Lille, 59046
France

Centre for Economic Policy Research (CEPR)

90-98 Goswell Road
London, EC1V 7RR
United Kingdom

Grigory Vilkov (Contact Author)

Frankfurt School of Finance & Management ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

HOME PAGE: http://www.vilkov.net

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