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Explaining the Magnitude of Liquidity Premia: The Roles of Return Predictability, Wealth Shocks, and State-Dependent Transaction Costs




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    • Lynch is with Stern School of Business, New York University, and Tan is with Fordham University, Graduate School of Business Administration. The authors would like to thank an anonymous referee; Editor Rob Stambaugh; Viral Acharya; George Constantinides; Ned Elton; Marty Gruber; Joel Hasbrouck; John Heaton; Lasse Pedersen; Hans Stoll; and participants of the NBER Spring Asset Pricing Group Meeting, the NYU Monday Finance Seminar, the NYU Macro-Finance Reading Group, the NHH Finance Seminar, the UCLA Finance Seminar, the Vanderbilt Finance Seminar, and the Yale Finance Seminar for helpful comments and suggestions. All remaining errors are of course the authors' responsibility.


Constantinides (1986) documents how the impact of transaction costs on per-annum liquidity premia in the standard dynamic allocation problem with i.i.d. returns is an order of magnitude smaller than the cost rate itself. Recent papers form portfolios sorted on liquidity measures and find spreads in expected per-annum return that are the same order of magnitude as the transaction cost spread. When we allow returns to be predictable and introduce wealth shocks calibrated to labor income, transaction costs are able to produce per-annum liquidity premia that are the same order of magnitude as the transaction cost spread.