Equilibrium Returns with Transaction Costs
26 Pages Posted: 29 Jul 2017 Last revised: 15 Sep 2017
Date Written: September 12, 2017
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
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