An Equilibrium Model for the Cross-Section of Liquidity Premia

35 Pages Posted: 12 Jan 2021

See all articles by Johannes Muhle-Karbe

Johannes Muhle-Karbe

Imperial College London - Department of Mathematics

Xiaofei Shi

Carnegie Mellon University - Department of Mathematical Sciences

Chen Yang

The Chinese University of Hong Kong (CUHK) - Department of Systems Engineering and Engineering Management

Date Written: November 26, 2020

Abstract

We study a risk-sharing economy where an arbitrary number of heterogenous agents trades an arbitrary number of risky assets subject to quadratic transaction costs. For linear state dynamics, the forward-backward stochastic differential equations characterizing equilibrium asset prices and trading strategies in this context reduce to a system of matrix-valued Riccati equations. We prove the existence of a unique global solution and provide explicit asymptotic expansions that allow us to approximate the corresponding equilibrium for small transaction costs. These tractable approximation formulas make it feasible to calibrate the model to time series of prices and trading volume, and to study the cross-section of liquidity premia earned by assets with higher and lower trading costs. This is illustrated by an empirical case study.

Keywords: asset pricing, Radner equilibrium, transaction costs, liquidity premia

JEL Classification: C68, D52, G11, G12

Suggested Citation

Muhle-Karbe, Johannes and Shi, Xiaofei and Yang, Chen, An Equilibrium Model for the Cross-Section of Liquidity Premia (November 26, 2020). Available at SSRN: https://ssrn.com/abstract=3738500 or http://dx.doi.org/10.2139/ssrn.3738500

Johannes Muhle-Karbe (Contact Author)

Imperial College London - Department of Mathematics ( email )

South Kensington Campus
Imperial College
LONDON, SW7 2AZ
United Kingdom

Xiaofei Shi

Carnegie Mellon University - Department of Mathematical Sciences ( email )

Pittsburgh, PA 15213-3890
United States

Chen Yang

The Chinese University of Hong Kong (CUHK) - Department of Systems Engineering and Engineering Management ( email )

Hong Kong
China

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