Optimal Portfolio Balancing Under Conventional Preferences and Transaction Costs Explains the Equity Premium Puzzle

50 Pages Posted: 10 Mar 2005

See all articles by Peter L. Swan

Peter L. Swan

University of New South Wales (UNSW Sydney; Financial Research Network (FIRN)

Date Written: March 2006

Abstract

Following Constantinides' (1986) seminal approach and introducing transaction costs in the Pagano (1989) model, conventional CARA investors with heterogeneous endowments trade to construct optimal portfolios. We calibrate to the 1896-1994 equity and bond markets to show that gains from trade are high and, thus, investors require a high illiquidity premium even for a modest transactional charge. Excluding risk premia, exchange of equity and bonds by N strategic investors, as , under a mere 1% round-trip transaction cost induces a 6% illiquidity (equity) premium. Unlike existing literature, our findings are consistent with most stylized empirical facts. We recover the elasticity of trading demand from the excess equity return to confirm a major implication of the model. Among many other, so called, anomalies, we appear to explain the apparent "irrational exuberance" of equity markets, the 600% price premium for otherwise identical "A" stock over "B" stock in China, the low risk-free rate, the 20% letter stock premium and the lower return on "on the run" bonds. Because illiquidity premia do not necessarily imply consumption volatility, variance bounds tests become irrelevant.

Keywords: equity-premium puzzle, asset prices, liquidity, trading, transactions cost

JEL Classification: G12, G11, G310, C61, D91, D92

Suggested Citation

Swan, Peter Lawrence, Optimal Portfolio Balancing Under Conventional Preferences and Transaction Costs Explains the Equity Premium Puzzle (March 2006). Available at SSRN: https://ssrn.com/abstract=674282 or http://dx.doi.org/10.2139/ssrn.674282

Peter Lawrence Swan (Contact Author)

University of New South Wales (UNSW Sydney ( email )

School of Banking and Finance
UNSW Business School
Sydney NSW, NSW 2052
Australia
+61 2 9385 5871 (Phone)
+61 2 9385 6347 (Fax)

HOME PAGE: http://https://www.business.unsw.edu.au/our-people/peterswan

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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