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

59 Pages Posted: 12 Dec 2013  

Adrian Buss

INSEAD

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: January 3, 2014

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, 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 (January 3, 2014). 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

INSEAD ( email )

Boulevard de Constance
F-77305 Fontainebleau Cedex
France
+33 160 72 44 84 (Phone)
+33 160 72 40 45 (Fax)

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 )

Sonnemannstra├če 9-11
Frankfurt am Main, 60314
Germany

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

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