Asset Prices in General Equilibrium with Recursive Utility and Illiquidity Induced by Transactions Costs

Project Start: 02/2014
Status: Completed
Researchers: Adrian Buss, Raman Uppal, Grigory Vilkov
Category: Financial Markets, Transparency Lab, Systemic Risk Lab

Topic and Objectives

The project studies the effect of proportional transaction costs on consumption-portfolio decisions and asset prices in a dynamic general equilibrium economy with multiple investors who have stochastic labor income and heterogeneous Epstein-Zin-Weil utility functions and a financial market with a single-period bond and two risky stocks, one of which incurs the transaction cost. The transaction cost gives rise to endogenous variations in liquidity.

Key Findings

  • Costs for trading a stock lead to a substantial reduction in the trading volume of that stock, but have only a small effect on the trading volume of the other stock and the bond.
  • Even in the presence of stochastic labor income, transaction costs have only a small effect on the consumption decisions of investors, and hence, on equity risk premia and the liquidity premium.
  • The effects of transaction costs on quantities such as the liquidity premium depend on whether the analysis is undertaken in general equilibrium or in partial equilibrium.

Related Working Papers

No. Author/s Title Year Research Area Keywords
5 Grigory Vilkov, Yan Xiao Option-Implied Information and Predictability of Extreme Returns 2013 Financial Markets, Transparency Lab, Systemic Risk Lab extreme value theory, tail measure, implied correlation, variance risk premium, option-implied distribution, predictability, portfolio optimization
41 Adrian Buss, Raman Uppal, Grigory Vilkov Asset Prices in General Equilibrium with Recursive Utility and Illiquidity Induced by Transactions Costs 2014 Financial Markets, Transparency Lab, Systemic Risk Lab liquidity premium, incomplete markets, portfolio choice, heterogeneous agents

 

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