Liquidation Shocks and Transaction Costs
34 Pages Posted: 14 Feb 2015
Date Written: February 12, 2015
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
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