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

The authors study 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. There are three main findings. One, 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. Two, 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. Three, 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.

The paper is under revision, and it will be submitted to a journal in the first half of 2015.