Ebook Equilibrium Interest Rate and Liquidity Premium with Transaction Costs
Transaction costs such as bid-ask spreads, brokerage commissions, exchange fees, and transaction taxes, are important in many financial markets. Considerable attention has focused on their impact on asset prices and subsequent investment decisions. For instance, how would a transaction tax, such as the one that has been proposed for the US, affect asset prices? How would information technology and financial market deregulation, both of which reduce transaction costs, affect asset prices?
Although transaction costs are mentioned in many asset pricing debates, they are generally absent from asset pricing models. Starting with Constantinides (1986), some papers study the optimal policy of an agent who invests in a riskless, liquid asset, and a risky, illiquid asset. These papers treat asset prices as exogenous. Amihud and Mendelson (1986), Aiyagari and Gertler (1991), Huang (1998), and Vayanos (1998) endogenize asset prices, assuming a riskless, liquid asset, and one or more illiquid assets. However, these papers treat the price of the liquid asset as exogenous, and only determine the price of the illiquid asset relative to the liquid asset. Heaton and Lucas (1996) assume a riskless, liquid asset, and a risky, illiquid asset. They endogenize the prices of both assets, but have to resort to numerical methods.
In this paper we develop a general equilibrium model with transaction costs. We assume an overlapping generations economy with two riskless assets and a numéraire consumption good. The first asset is liquid while the second asset carries proportional transaction costs. Agents receive labor income and trade the assets for life-cycle purposes. In contrast to other equilibrium models with transaction costs, we endogenize the prices of both the liquid and the illiquid asset. Moreover, our model is very simple and tractable. Our assumptions of riskless assets and life-cycle trading, which are made for tractability, are admittedly special. At the same time, our assumptions on agents’ preferences and labor income streams are very general. The only restriction that we impose, is that without transaction costs there exists an equilibrium where agents’ wealth is increasing and then decreasing with age.
We show that with transaction costs, agents first buy the illiquid asset, next buy the liquid asset, then sell the liquid asset, and finally sell the illiquid asset. For a short holding period transaction costs are important and the liquid asset is the better investment, despite being more expensive than the illiquid asset. For a long period transaction costs are less important and the illiquid asset is the better investment.
As in Amihud and Mendelson (1986), each asset has its own clientele.
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