Does 'Illiquidity' Rather than 'Risk Aversion' Explain the Equity Premium Puzzle?: The Value of Endogenous Market Trading

52 Pages Posted: 18 Dec 2000

See all articles by Peter L. Swan

Peter L. Swan

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

Date Written: June 7, 2002


Yes. I aim to establish empirically that the "equity premium" puzzle, with its 6% excess return per annum over Treasury bills for the last 100 years on the NYSE, can be explained once the value of endogenous stock market trading is incorporated into investor preferences. Within my framework, investors enjoy trading. According to my model, the "investor surplus" from trading liquid Treasury bills relative to illiquid equity is exactly compensated for by the expected equity premium. Observed transaction cost and liquidity differentials between equity and bills are consistent with the premium. Extensive tests are carried out on Australian and US NYSE data for 1955-98. The puzzle concerning the volatility of the stochastic discount factor also appears to be explained by trading behavior, which is of comparable volatility. Reasonably accurate estimates of transactions costs are extracted just from daily dividend yields and turnover. Transaction costs would need to be 400% higher to explain the premium by the "amortized spread", together with exogenous trading and habit formation. An ability to create unlimited wealth, implicit in some existing models, no longer applies. Additionally, the model explains the further 15-20% pa discount on illiquid "letter" stock.

Keywords: equity premium, asset prices, liquidity, trading, transaction cost, amortized spread.

JEL Classification: G120, G110, G200

Suggested Citation

Swan, Peter Lawrence, Does 'Illiquidity' Rather than 'Risk Aversion' Explain the Equity Premium Puzzle?: The Value of Endogenous Market Trading (June 7, 2002). University of Sydney School of Business Working Paper; EFA 2002 Berlin Meetings Discussion Paper, Available at SSRN: or

Peter Lawrence Swan (Contact Author)

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


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