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

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.