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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/26422
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| Title: | Explaining the Magnitude of Liquidity Premia: The Roles of Return
Predictability, Wealth Shocks and State-dependent Transaction Costs |
| Authors: | Lynch, Anthony W.
Tan, Sinan |
| Issue Date: | Dec-2004 |
| Series/Report no.: | FIN-05-020 |
| Abstract: | The seminal work of Constantinides (1986) documents how, when the risky
return is calibrated to the U.S. market return, the impact of
transaction costs on per-annum liquidity premia is an order of magnitude
smaller than the cost rate itself. A number of recent papers have formed
portfolios sorted on liquidity measures and found a spread in expected
per-annum return that is definitely not an order of magnitude smaller
than the transaction cost spread: the expected per-annum return spread
is found to be around 6-7% per annum. Our paper bridges the gap between
Constantinides’ theoretical result and the empirical magnitude of
the liquidity premium by examining dynamic portfolio choice with
transaction costs in a variety of more elaborate settings that move the
problem closer to the one solved by real-world investors. In particular,
we allow returns to be predictable and transaction costs to be
stochastic, and we introduce wealth shocks, both stationary
multiplicative and labor income. With predictable returns, we also allow
the wealth shocks and transaction costs to be state dependent. We find
that adding these real world complications to the canonical problem can
cause transactions costs to produce per-annum liquidity premia that are
no longer an order of magnitude smaller than the rate, but are instead
the same order of magnitude. For example, predictable returns and i.i.d.
labor income growth causes the liquidity premium for an agent with a
wealth to monthly labor income ratio of 0 or 10 to be 1.68% and 1.20%
respectively; these are 21-fold and 15-fold increases, respectively,
relative to that in the standard i.i.d. return case. We conclude that
the effect of proportional transaction costs on the standard consumption
and portfolio allocation problem with i.i.d. returns can be materially
altered by reasonable perturbations that bring the problem closer to the
one investors are actually solving. |
| URI: | http://hdl.handle.net/2451/26422 |
| Appears in Collections: | Finance Working Papers
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