Between 1896 and 1994 the yearly simple geometric mean equity premium for New York Stock Exchange (NYSE) value-weighted stocks was six percent (Campbell, Lo and MacKinlay, 1997) and has been approximately eight percent for the last fifty years (Cochrane, 2005). In a celebrated paper Mehra and Prescott (1985), hereafter MP, attempt to account for this premium using simulations of an inter temporal equilibrium growth model with a representative consumer/investor, abstracting from transaction costs, security market microstructure, liquidity considerations, and other frictions. They are able to account for only a negligible proportion of this premium with a maximum of 0.4% explained by risk aversion.
MP and the subsequent literature surveyed by Cochrane (2005) and Campbell, Lo and MacKinlay (1997) focus on representative agent equilibria with agents identical in all respects, including endowments. These are models of perfectly competitive market equilibria with no market frictions, for which a representative agent can be derived through Pareto optimality, and relative prices can be determined strictly from aggregate risk preferences and irrespective of trading activity amongst market participants.
Once market frictions are introduced, risk preferences need to be balanced with illiquidity costs, and hence relative prices are impacted by relative liquidity across investment assets. Clearly, this impact can only be observed when investors have an incentive to trade, and for that they must differ in at least one respect; here, endowments. Essentially, we replace the representative investor by investors with differing endowments to motive trading while retaining the assumption of identical preferences. We show that, preserving all the standard assumptions of rationality, utility maximization, and even abstracting from the effects of information and beliefs, a simple exchange model with quite modest barriers to trade explains the major stylized and empirical facts about equity and bond market returns and trading turnover over the last 100 years.
We establish in a variety of settings that the (midpoint) price of an asset is unaffected by impediments to trade such as a small number of participants (oligoposony market power) or quadratic transaction costs. Superficially, this would suggest that illiquidity and trade impediments can never impact on asset returns. Heumann (2005), in a Nash-equilibrium trading model of market impact costs also finds that illiquidity due to trader oligopsony power is not priced. The trading price is independent of the number of traders, a result we also obtain. He attributes what he calls a surprising result to the two-sided nature of trading: “buyers demand a price discount and sellers demand a price premium, and these effects cancel each other out (p.5).” This result, however, hinges upon the assumption of free leverage. We show that in the presence of transaction costs, borrowing constraints generate a shadow price for liquidity which is not only important but can also dominate the price of risk.
This apparent cancelling out of what are mutual harms due to illiquidity is puzzling as both trader welfare and liquidity is clearly improving in the number of participants, despite the implication of the finding that the number of participants is irrelevant for the outcome. In the model, a smaller number of participants make all parties worse off as the optimal (first-best) level of trading with an infinite number of participants is unobtainable. This means that there is no cancelling out of welfare losses. If there is a choice between regimes, in the less-liquid regime there must be a compensating fall in the asset price relative to the liquid regime. Garleanu and Pedersen (2004) obtain a similar puzzling cancelling out for informed and liquidity trades with an intuitive explanation in common with Heumann (2005).
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