Long Horizons, High Risk Aversion, and Endogeneous Spreads
AbstractFor an investor with constant absolute risk aversion and a long horizon, who trades in a market with constant investment opportunities and small proportional transaction costs, we obtain explicitly the optimal investment policy, its implied welfare, liquidity premium, and trading volume. We identify these quantities as the limits of their isoelastic counterparts for high levels of risk aversion. The results are robust with respect to finite horizons, and extend to multiple uncorrelated risky assets. In this setting, we study a Stackelberg equilibrium, led by a risk-neutral, monopolistic market maker who sets the spread as to maximize profits. The resulting endogenous spread depends on investment opportunities only, and is of the order of a few percentage points for realistic parameter values.
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Bibliographic InfoPaper provided by arXiv.org in its series Papers with number 1110.1214.
Date of creation: Oct 2011
Date of revision: Jul 2012
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Web page: http://arxiv.org/
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-10-15 (All new papers)
- NEP-MST-2011-10-15 (Market Microstructure)
- NEP-UPT-2011-10-15 (Utility Models & Prospect Theory)
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