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Equilibrium Returns with Transaction Costs

26 Pages Posted: 29 Jul 2017 Last revised: 15 Sep 2017

Bruno Bouchard

Université Paris Dauphine - CEREMADE

Masaaki Fukasawa

Osaka University

Martin Herdegen

University of Warwick - Department of Statistics

Johannes Muhle-Karbe

Carnegie Mellon University - Department of Mathematical Sciences

Date Written: September 12, 2017

Abstract

We study how trading costs are reflected in equilibrium returns. To this end, we develop a tractable continuous-time risk-sharing model, where heterogeneous mean-variance investors trade subject to a quadratic transaction cost. The corresponding equilibrium is characterized as the unique solution of a system of coupled but linear forward-backward stochastic differential equations. Explicit solutions are obtained in a number of concrete settings. The sluggishness of the frictional portfolios makes the corresponding equilibrium returns mean-reverting. Compared to the frictionless case, expected returns are higher if the more risk-averse agents are net sellers or if the asset supply expands over time.

Keywords: equilibrium, transaction costs, liquidity premium

JEL Classification: C68, D52, G11, G12

Suggested Citation

Bouchard, Bruno and Fukasawa, Masaaki and Herdegen, Martin and Muhle-Karbe, Johannes, Equilibrium Returns with Transaction Costs (September 12, 2017). Available at SSRN: https://ssrn.com/abstract=3009183

Bruno Bouchard

Université Paris Dauphine - CEREMADE ( email )

Place du Marechal de Lattre de Tassigny
Paris Cedex 16, 75775
France

Masaaki Fukasawa

Osaka University

1-1 Yamadaoka
Suita
Osaka, 565-0871
Japan

Martin Herdegen

University of Warwick - Department of Statistics ( email )

Coventry CV4 7AL
United Kingdom

Johannes Muhle-Karbe (Contact Author)

Carnegie Mellon University - Department of Mathematical Sciences ( email )

Pittsburgh, PA 15213-3890
United States

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