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
Date Written: February 18, 2015
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
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