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An Equilibrium Model for the Cross Section of Liquidity Premia

Author

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  • Johannes Muhle-Karbe

    (Department of Mathematics, Imperial College London, London SW7 2AZ, United Kingdom)

  • Xiaofei Shi

    (Department of Statistical Sciences, University of Toronto, Toronto, Ontario M5S 3G3, Canada; Department of Statistics, Columbia University, New York, New York 10027)

  • Chen Yang

    (Department of Systems Engineering and Engineering Management, The Chinese University of Hong Kong, Shatin, N.T., Hong Kong)

Abstract

We study a risk-sharing economy where an arbitrary number of heterogeneous agents trades an arbitrary number of risky assets subject to quadratic transaction costs. For linear state dynamics, the forward–backward stochastic differential equations characterizing equilibrium asset prices and trading strategies in this context reduce to a coupled system of matrix-valued Riccati equations. We prove the existence of a unique global solution and provide explicit asymptotic expansions that allow us to approximate the corresponding equilibrium for small transaction costs. These tractable approximation formulas make it feasible to calibrate the model to time series of prices and trading volume, and to study the cross section of liquidity premia earned by assets with higher and lower trading costs. This is illustrated by an empirical case study.

Suggested Citation

  • Johannes Muhle-Karbe & Xiaofei Shi & Chen Yang, 2023. "An Equilibrium Model for the Cross Section of Liquidity Premia," Mathematics of Operations Research, INFORMS, vol. 48(3), pages 1423-1453, August.
    • Handle: RePEc:inm:ormoor:v:48:y:2023:i:3:p:1423-1453
    DOI: 10.1287/moor.2022.1307
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