Liquidation Shocks and Transaction Costs

34 Pages Posted: 14 Feb 2015

See all articles by Bong-Gyu Jang

Bong-Gyu Jang

Pohang University of Science and Technology (POSTECH)

Hyeng Keun Koo

Ajou University - Department of Business Administration

Seungkyu Lee

Pohang University of Science and Technology (POSTECH) - Dept. of Industrial and Management Engineering

Date Written: February 12, 2015

Abstract

This paper investigates an Epstein-Zin type investors' optimal consumption and portfolio choice problem in the presence of transaction costs and liquidation shocks. We model the liquidation shocks as a Poisson process, which enforces the representative investors to liquidate their wealth in an illiquid asset. We calculate an average liquidity premium to transaction cost ratio with the steady state distribution and show that the liquidation shocks can significantly amplify the effect of the transaction costs on the excess rate of return of the illiquid asset. Our further numerical analysis also demonstrates how the level of elasticity of intertemporal substitution, as well as relative risk aversion, affects the investors' optimal trading behavior.

Keywords: recursive utility, transaction cost, elasticity of intertemporal substitution, wealth shock, liquidation shock

JEL Classification: C61, G11

Suggested Citation

Jang, Bong-Gyu and Koo, Hyeng Keun and Lee, Seungkyu, Liquidation Shocks and Transaction Costs (February 12, 2015). Available at SSRN: https://ssrn.com/abstract=2564371 or http://dx.doi.org/10.2139/ssrn.2564371

Bong-Gyu Jang

Pohang University of Science and Technology (POSTECH) ( email )

77 Cheongam-ro
Pohang
Korea, Republic of (South Korea)

Hyeng Keun Koo

Ajou University - Department of Business Administration ( email )

206 Worldcup-ro
Yeongtong-gu
Suwon, 443-749
Korea, Republic of (South Korea)

Seungkyu Lee (Contact Author)

Pohang University of Science and Technology (POSTECH) - Dept. of Industrial and Management Engineering ( email )

Dep. Industrial and Management Engineering POSTECH
San 31 Hyoja-dong Nam-gu
Pohang, Kyung-buk 790-783
Korea
82-(0)10-2790-4237 (Phone)

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