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