Transaction Costs, Frequent Trading, and Stock Prices.

Abstract

I consider the effects of quadratic transaction costs on stock prices. It is optimal for investors to trade frequently with relatively small amounts in the presence of such costs. Contrary to previous papers that report that the strongest effects that transaction costs can have on the risk premium are of the order of a few percent, I find that the effects could be of the order of tens of percent conditioned that investors are sufficiently heterogeneous. Frequent trading in the presence of transaction costs substantially changes heterogeneity in demands across investors, resulting in a significant liquidity premium.

Keywords: Equilibrium, Asset Pricing, Transaction Costs

JEL Classification: G11, G12