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Transaction costs, trading volume, and the liquidity premium

Author

Listed:
  • Stefan Gerhold
  • Paolo Guasoni
  • Johannes Muhle-Karbe
  • Walter Schachermayer

Abstract

In a market with one safe and one risky asset, an investor with a long horizon, constant investment opportunities and constant relative risk aversion trades with small proportional transaction costs. We derive explicit formulas for the optimal investment policy, its implied welfare, liquidity premium, and trading volume. At the first order, the liquidity premium equals the spread, times share turnover, times a universal constant. The results are robust to consumption and finite horizons. We exploit the equivalence of the transaction cost market to another frictionless market, with a shadow risky asset, in which investment opportunities are stochastic. The shadow price is also found explicitly. Copyright Springer-Verlag Berlin Heidelberg 2014

Suggested Citation

  • Stefan Gerhold & Paolo Guasoni & Johannes Muhle-Karbe & Walter Schachermayer, 2014. "Transaction costs, trading volume, and the liquidity premium," Finance and Stochastics, Springer, vol. 18(1), pages 1-37, January.
    • Handle: RePEc:spr:finsto:v:18:y:2014:i:1:p:1-37
    DOI: 10.1007/s00780-013-0210-y
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    References listed on IDEAS

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    More about this item

    Keywords

    Transaction costs; Long-run; Portfolio choice; Liquidity premium; Trading volume; 91G10; 91G80; G11; G12;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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