The Liquidity Component of the Equity Premium

36 Pages Posted: 8 Mar 2008

See all articles by Peter L. Swan

Peter L. Swan

University of New South Wales (UNSW Sydney; Financial Research Network (FIRN)

André Levy

Australian Prudential Regulation Authority

Multiple version iconThere are 2 versions of this paper

Date Written: February 21, 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.

Keywords: equity-premium puzzle, asset prices, liquidity, trading, transaction cost

JEL Classification: G12, G11, G31, C61, D91, D92

Suggested Citation

Swan, Peter Lawrence and Levy, André, The Liquidity Component of the Equity Premium (February 21, 2008). Available at SSRN: or

Peter Lawrence Swan

University of New South Wales (UNSW Sydney ( email )

School of Banking and Finance
UNSW Business School
Sydney NSW, NSW 2052
+61 2 9385 5871 (Phone)
+61 2 9385 6347 (Fax)

HOME PAGE: http://

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane


André Levy (Contact Author)

Australian Prudential Regulation Authority ( email )

400 George Street
Sydney, NSW 2000
61292103219 (Phone)


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