IDEAS home Printed from https://ideas.repec.org/p/ysm/somwrk/ysm188.html
   My bibliography  Save this paper

Asset Prices and Trading Volume Under Fixed Transactions Costs

Author

Listed:
  • Andrew Lo
  • Harry Mamaysky
  • Jiang Wang

Abstract

We propose a dynamic equilibrium model of asset prices and trading volume with heterogeneous agents fixed transactions costs. We show that even small fixed costs can give rise to large "no-trade" regions for each agent's optimal trading policy and a significant illiquidity discount in asset prices. We perform a calibration exercise to illustrate the empirical relevance of our model for aggregate data. Our model also has implications for the dynamics of order flow, bid/ask spreads, market depth, the allocation of trading costs between buyers and sellers, and other aspects of market microstructure, including a square-root power law between trading volume and fixed costs which we confirm using historical US stock market data from 1993 to 1997.

Suggested Citation

  • Andrew Lo & Harry Mamaysky & Jiang Wang, 2001. "Asset Prices and Trading Volume Under Fixed Transactions Costs," Yale School of Management Working Papers ysm188, Yale School of Management, revised 01 Sep 2009.
    • Handle: RePEc:ysm:somwrk:ysm188
    as

    Download full text from publisher

    File URL: http://icfpub.som.yale.edu/publications/2403
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Merton H. Miller & Daniel Orr, 1966. "A Model of the Demand for Money by Firms," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 80(3), pages 413-435.
    2. N. Gregory Mankiw, 1985. "Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 100(2), pages 529-538.
    3. Garman, Mark B. & Ohlson, James A., 1981. "Valuation of risky assets in arbitrage-free economies with transactions costs," Journal of Financial Economics, Elsevier, vol. 9(3), pages 271-280, September.
    4. Foster, F Douglas & Viswanathan, S, 1990. "A Theory of the Interday Variations in Volume, Variance, and Trading Costs in Securities Markets," The Review of Financial Studies, Society for Financial Studies, vol. 3(4), pages 593-624.
    5. Aiyagari, S. Rao & Gertler, Mark, 1991. "Asset returns with transactions costs and uninsured individual risk," Journal of Monetary Economics, Elsevier, vol. 27(3), pages 311-331, June.
    6. Abel, Andrew B & Eberly, Janice C, 1994. "A Unified Model of Investment under Uncertainty," American Economic Review, American Economic Association, vol. 84(5), pages 1369-1384, December.
    7. Thomas W. Epps, 1976. "The Demand for Brokers' Services: The Relation Between Security Trading Volume and Transaction Cost," Bell Journal of Economics, The RAND Corporation, vol. 7(1), pages 163-194, Spring.
    8. Grossman, Sanford J & Laroque, Guy, 1990. "Asset Pricing and Optimal Portfolio Choice in the Presence of Illiquid Durable Consumption Goods," Econometrica, Econometric Society, vol. 58(1), pages 25-51, January.
    9. Robert A. Jarrow, 2008. "Market Manipulation, Bubbles, Corners, and Short Squeezes," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 6, pages 105-130, World Scientific Publishing Co. Pte. Ltd..
    10. Donald B. Keim & Ananth Madhavan, "undated". "Execution Costs and Investment Performance: An Empirical Analysis of Institutional Equity Trades (Revision of 26-94)," Rodney L. White Center for Financial Research Working Papers 9-95, Wharton School Rodney L. White Center for Financial Research.
    11. David Romer, 1986. "A Simple General Equilibrium Version of the Baumol-Tobin Model," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 101(4), pages 663-685.
    12. Huang, Jennifer & Wang, Jiang, 1997. "Market Structure, Security Prices, And Informational Efficiency," Macroeconomic Dynamics, Cambridge University Press, vol. 1(1), pages 169-205, January.
    13. Jean-Luc Vila & Dimitri Vayanos, 1999. "Equilibrium interest rate and liquidity premium with transaction costs," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 13(3), pages 509-539.
    14. Abel Cadenillas & Fernando Zapatero, 2000. "Classical and Impulse Stochastic Control of the Exchange Rate Using Interest Rates and Reserves," Mathematical Finance, Wiley Blackwell, vol. 10(2), pages 141-156, April.
    15. J. Michael Harrison & Thomas M. Sellke & Allison J. Taylor, 1983. "Impulse Control of Brownian Motion," Mathematics of Operations Research, INFORMS, vol. 8(3), pages 454-466, August.
    16. Hansen, Lars Peter & Jagannathan, Ravi, 1991. "Implications of Security Market Data for Models of Dynamic Economies," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 225-262, April.
    17. Andrew J. Morton & Stanley R. Pliska, 1995. "Optimal Portfolio Management With Fixed Transaction Costs," Mathematical Finance, Wiley Blackwell, vol. 5(4), pages 337-356, October.
    18. William J. Baumol, 1952. "The Transactions Demand for Cash: An Inventory Theoretic Approach," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 66(4), pages 545-556.
    19. Vayanos, Dimitri, 1998. "Transaction Costs and Asset Prices: A Dynamic Equilibrium Model," The Review of Financial Studies, Society for Financial Studies, vol. 11(1), pages 1-58.
    20. Angel, James J, 1997. "Tick Size, Share Prices, and Stock Splits," Journal of Finance, American Finance Association, vol. 52(2), pages 655-681, June.
    21. Pilotte, Eugene & Manuel, Timothy, 1996. "The market's response to recurring events The case of stock splits," Journal of Financial Economics, Elsevier, vol. 41(1), pages 111-127, May.
    22. Dixit, Avinash K, 1989. "Entry and Exit Decisions under Uncertainty," Journal of Political Economy, University of Chicago Press, vol. 97(3), pages 620-638, June.
    23. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March.
    24. George M. Constantinides, 2005. "Capital Market Equilibrium with Transaction Costs," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 7, pages 207-227, World Scientific Publishing Co. Pte. Ltd..
    25. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
    26. Robert J. Barro, 1972. "A Theory of Monopolistic Price Adjustment," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 39(1), pages 17-26.
    27. He, Hua & Modest, David M, 1995. "Market Frictions and Consumption-Based Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 103(1), pages 94-117, February.
    28. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 443-487, June.
    29. Albert S. Kyle, 1989. "Informed Speculation with Imperfect Competition," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 56(3), pages 317-355.
    30. Pindyck, Robert S, 1988. "Irreversible Investment, Capacity Choice, and the Value of the Firm," American Economic Review, American Economic Association, vol. 78(5), pages 969-985, December.
    31. Luttmer, Erzo G J, 1996. "Asset Pricing in Economies with Frictions," Econometrica, Econometric Society, vol. 64(6), pages 1439-1467, November.
    32. Bernanke, Ben, 1985. "Adjustment costs, durables, and aggregate consumption," Journal of Monetary Economics, Elsevier, vol. 15(1), pages 41-68, January.
    33. Lo, Andrew W & Wang, Jiang, 2000. "Trading Volume: Definitions, Data Analysis, and Implications of Portfolio Theory," The Review of Financial Studies, Society for Financial Studies, vol. 13(2), pages 257-300.
    34. Dumas, Bernard & Luciano, Elisa, 1991. "An Exact Solution to a Dynamic Portfolio Choice Problem under Transactions Costs," Journal of Finance, American Finance Association, vol. 46(2), pages 577-595, June.
    35. Jerome F. Eastham & Kevin J. Hastings, 1988. "Optimal Impulse Control of Portfolios," Mathematics of Operations Research, INFORMS, vol. 13(4), pages 588-605, November.
    36. Harold Demsetz, 1968. "The Cost of Transacting," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 82(1), pages 33-53.
    37. C. Atkinson & P. Wilmott, 1995. "Portfolio Management With Transaction Costs: An Asymptotic Analysis Of The Morton And Pliska Model," Mathematical Finance, Wiley Blackwell, vol. 5(4), pages 357-367, October.
    38. Jacob A. Frenkel & Boyan Jovanovic, 1980. "On Transactions and Precautionary Demand for Money," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 95(1), pages 25-43.
    39. Giuseppe Bertola & Ricardo J. Caballero, 1990. "Kinked Adjustment Costs and Aggregate Dynamics," NBER Chapters, in: NBER Macroeconomics Annual 1990, Volume 5, pages 237-296, National Bureau of Economic Research, Inc.
    40. Grossman, Sanford & Weiss, Laurence, 1983. "A Transactions-Based Model of the Monetary Transmission Mechanism," American Economic Review, American Economic Association, vol. 73(5), pages 871-880, December.
    41. Easley, David & O'Hara, Maureen, 1987. "Price, trade size, and information in securities markets," Journal of Financial Economics, Elsevier, vol. 19(1), pages 69-90, September.
    42. George M. Constantinides, 1976. "Stochastic Cash Management with Fixed and Proportional Transaction Costs," Management Science, INFORMS, vol. 22(12), pages 1320-1331, August.
    43. John Y. Campbell & Albert S. Kyle, 1993. "Smart Money, Noise Trading and Stock Price Behaviour," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 60(1), pages 1-34.
    44. Brennan, Michael J. & Copeland, Thomas E., 1988. "Stock splits, stock prices, and transaction costs," Journal of Financial Economics, Elsevier, vol. 22(1), pages 83-101, October.
    45. Aiyagari, S. Rao & Gertler, Mark, 1991. "Asset returns with transactions costs and uninsured individual risk," Journal of Monetary Economics, Elsevier, vol. 27(3), pages 311-331, June.
    46. Duffie, Darrell & Sun, Tong-sheng, 1990. "Transactions costs and portfolio choice in a discrete-continuous-time setting," Journal of Economic Dynamics and Control, Elsevier, vol. 14(1), pages 35-51, February.
    47. Eytan Sheshinski & Yoram Weiss, 1977. "Inflation and Costs of Price Adjustment," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 44(2), pages 287-303.
    48. Conroy, Robert M & Harris, Robert S & Benet, Bruce A, 1990. "The Effects of Stock Splits on Bid-Ask Spreads," Journal of Finance, American Finance Association, vol. 45(4), pages 1285-1295, September.
    49. Bernard Bensaid & Jean‐Philippe Lesne & Henri Pagès & José Scheinkman, 1992. "Derivative Asset Pricing With Transaction Costs1," Mathematical Finance, Wiley Blackwell, vol. 2(2), pages 63-86, April.
    50. Erzo G. J. Luttmer, 1999. "What Level of Fixed Costs Can Reconcile Consumption and Stock Returns?," Journal of Political Economy, University of Chicago Press, vol. 107(5), pages 969-997, October.
    51. Ralf Korn, 1998. "Portfolio optimisation with strictly positive transaction costs and impulse control," Finance and Stochastics, Springer, vol. 2(2), pages 85-114.
    52. Dumas, Bernard, 1992. "Dynamic Equilibrium and the Real Exchange Rate in a Spatially Separated World," The Review of Financial Studies, Society for Financial Studies, vol. 5(2), pages 153-180.
    53. Stoll, Hans R, 1989. " Inferring the Components of the Bid-Ask Spread: Theory and Empirical Tests," Journal of Finance, American Finance Association, vol. 44(1), pages 115-134, March.
    54. Blume, Marshall E & Friend, Irwin, 1974. "Risk, Investment Strategy and the Long-Run Rates of Return," The Review of Economics and Statistics, MIT Press, vol. 56(3), pages 259-269, August.
    55. Kraus, Alan & Stoll, Hans R, 1972. "Price Impacts of Block Trading on the New York Stock Exchange," Journal of Finance, American Finance Association, vol. 27(3), pages 569-588, June.
    56. Ricardo J. Caballero & Eduardo M. R. A. Engel, 1993. "Heterogeneity and Output Fluctuations in a Dynamic Menu-Cost Economy," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 60(1), pages 95-119.
    57. Wang, Jiang, 1994. "A Model of Competitive Stock Trading Volume," Journal of Political Economy, University of Chicago Press, vol. 102(1), pages 127-168, February.
    58. Lamoureux, Christopher G & Poon, Percy, 1987. "The Market Reaction to Stock Splits," Journal of Finance, American Finance Association, vol. 42(5), pages 1347-1370, December.
    59. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-1335, November.
    60. McNichols, Maureen & Dravid, Ajay, 1990. "Stock Dividends, Stock Splits, and Signaling," Journal of Finance, American Finance Association, vol. 45(3), pages 857-879, July.
    61. Magill, Michael J. P. & Constantinides, George M., 1976. "Portfolio selection with transactions costs," Journal of Economic Theory, Elsevier, vol. 13(2), pages 245-263, October.
    62. Stiglitz, J.E., 1989. "Using Tax Policy To Curb Speculative Short-Term Trading," Papers t2, Columbia - Center for Futures Markets.
    63. Brennan, M. J., 1975. "The Optimal Number of Securities in a Risky Asset Portfolio When There Are Fixed Costs of Transacting: Theory and Some Empirical Results," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 10(3), pages 483-496, September.
    64. Caplin, Andrew S, 1985. "The Variability of Aggregate Demand with (S, s) Inventory Policies," Econometrica, Econometric Society, vol. 53(6), pages 1395-1409, November.
    65. Uppal, Raman, 1993. "A General Equilibrium Model of International Portfolio Choice," Journal of Finance, American Finance Association, vol. 48(2), pages 529-553, June.
    66. VIAL, Jean-Philippe, 1972. "A continuous time model for the cash balance problem," LIDAM Reprints CORE 127, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
    67. Tuckman, Bruce & Vila, Jean-Luc, 1992. "Arbitrage with Holding Costs: A Utility-Based Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1283-1302, September.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Bertsimas, Dimitris & Lo, Andrew W., 1998. "Optimal control of execution costs," Journal of Financial Markets, Elsevier, vol. 1(1), pages 1-50, April.
    2. Vayanos, Dimitri & Wang, Jiang, 2013. "Market Liquidity—Theory and Empirical Evidence ," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, volume 2, chapter 0, pages 1289-1361, Elsevier.
    3. Dimitri Vayanos & Jiang Wang, 2012. "Market Liquidity -- Theory and Empirical Evidence," NBER Working Papers 18251, National Bureau of Economic Research, Inc.
    4. Adrian Buss & Bernard Dumas, 2019. "The Dynamic Properties of Financial‐Market Equilibrium with Trading Fees," Journal of Finance, American Finance Association, vol. 74(2), pages 795-844, April.
    5. Huang, Ming, 2003. "Liquidity shocks and equilibrium liquidity premia," Journal of Economic Theory, Elsevier, vol. 109(1), pages 104-129, March.
    6. Suresh M. Sundaresan, 2000. "Continuous‐Time Methods in Finance: A Review and an Assessment," Journal of Finance, American Finance Association, vol. 55(4), pages 1569-1622, August.
    7. Vayanos, Dimitri & Wang, Jiang, 2009. "Liquidity and asset prices: a united framework," LSE Research Online Documents on Economics 29303, London School of Economics and Political Science, LSE Library.
    8. Gautam Goswami & Milind Shrikhande & Liuren Wu, 2002. "A Dynamic Equilibrium Model of Real Exchange Rates with General Transaction Costs," Finance 0207016, University Library of Munich, Germany.
    9. Guo, Ming & Ou-Yang, Hui, 2021. "Alpha decay and Sharpe ratio: Two measures of investor performance," Economic Modelling, Elsevier, vol. 104(C).
    10. Matthew Pritsker, 2005. "Large investors: implications for equilibrium asset, returns, shock absorption, and liquidity," Finance and Economics Discussion Series 2005-36, Board of Governors of the Federal Reserve System (U.S.).
    11. Sugato Chakravarty & Asani Sarkar, 1999. "Liquidity in U.S. fixed income markets: a comparison of the bid-ask spread in corporate, government and municipal bond markets," Staff Reports 73, Federal Reserve Bank of New York.
    12. Dumas, Bernard & Buss, Adrian, 2015. "Trading Fees and Slow-Moving Capital," CEPR Discussion Papers 10737, C.E.P.R. Discussion Papers.
    13. Vayanos, Dimitri, 1998. "Transaction Costs and Asset Prices: A Dynamic Equilibrium Model," The Review of Financial Studies, Society for Financial Studies, vol. 11(1), pages 1-58.
    14. Francisco Gomes & Alexander Michaelides, 2005. "Optimal Life‐Cycle Asset Allocation: Understanding the Empirical Evidence," Journal of Finance, American Finance Association, vol. 60(2), pages 869-904, April.
    15. Albuquerque, Rui & Song, Shiyun & Yao, Chen, 2017. "The Price Effects of Liquidity Shocks: A Study of SEC’s Tick-Size Experiment," CEPR Discussion Papers 12486, C.E.P.R. Discussion Papers.
    16. Chalmers, John M. R. & Kadlec, Gregory B., 1998. "An empirical examination of the amortized spread," Journal of Financial Economics, Elsevier, vol. 48(2), pages 159-188, May.
    17. Albuquerque, Rui & Song, Shiyun & Yao, Chen, 2020. "The price effects of liquidity shocks: A study of the SEC’s tick size experiment," Journal of Financial Economics, Elsevier, vol. 138(3), pages 700-724.
    18. Jiang Wang, 2002. "Trading Volume and Asset Prices," Annals of Economics and Finance, Society for AEF, vol. 3(2), pages 299-359, November.
    19. Kris Jacobs, 2002. "The Rate of Risk Aversion May Be Lower Than You Think," CIRANO Working Papers 2002s-08, CIRANO.
    20. Vayanos, Dimitri & Wang, Tan, 2007. "Search and endogenous concentration of liquidity in asset markets," Journal of Economic Theory, Elsevier, vol. 136(1), pages 66-104, September.

    More about this item

    Keywords

    Asset Pricing; Liquidity; Trading Volume; Transaction Costs;
    All these keywords.

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:ysm:somwrk:ysm188. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: the person in charge (email available below). General contact details of provider: https://edirc.repec.org/data/smyalus.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.