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Liquidity Premia and Transaction Costs

Authors

  • BONG-GYU JANG,

  • HYENG KEUN KOO,

  • HONG LIU,

  • MARK LOEWENSTEIN

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    • Jang is from the Financial Supervisory Service of Korea; Koo is from the Department of Business Administration of Ajou University, Korea; Liu is from the Olin School of Business of Washington University in St. Louis; and Loewenstein is from the Robert H. Smith School of Business of the University of Maryland. We thank George Constantinides; Phil Dybvig; Jingzhi Huang; Jiang Wang; and seminar participants at the 2006 American Finance Association conference, the 2005 China International Conference in Finance, the University of Illinois at Chicago, and Washington University in St. Louis for helpful comments. We are especially grateful to an anonymous referee and Rob Stambaugh (the Editor) for their useful suggestions. All errors are our responsibility.

ABSTRACT

Standard literature concludes that transaction costs only have a second-order effect on liquidity premia. We show that this conclusion depends crucially on the assumption of a constant investment opportunity set. In a regime-switching model in which the investment opportunity set varies over time, we explicitly characterize the optimal consumption and investment strategy. In contrast to the standard literature, we find that transaction costs can have a first-order effect on liquidity premia. However, with reasonably calibrated parameters, the presence of transaction costs still cannot fully explain the equity premium puzzle.

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