Financial Market Frictions

Abstract

What is a market friction? In the context of the capital asset pricing model, this article defines a financial market friction as anything that interferes with trade. This interference includes two dimensions. First, financial market frictions cause a market participant to deviate from holding the market portfolio. By implication, these frictions can cause a market participant to be exposed to more or less risk than she might prefer. This definition at first seems very limited but is, in fact, only as limited as the definition of the market portfolio. In this article, the term market portfolio means not only financial assets but also real estate, human capital, investors’ time, and so on. Put differently and somewhat less obscurely, financial market frictions generate costs that interfere with trades that rational individuals make (or would make in the absence of market frictions).

Keywords: market frictions, transactions costs

JEL Classification: G10, G20