Capital Market Equilibrium with Transaction Costs

Abstract

A two-asset, intertemporal portfolio selection model is formulated incorporating proportional transaction costs. The demand for assets is shown to be sensitive to these costs. However, transaction costs have only a second-order effect on the liquidity premia implied by equilibrium asset returns: the derived utility is insensitive to deviations from the optimal portfolio proportions, and investors accommodate large transaction costs by drastically reducing the frequency and volume of trade. A single-period model with an appropriately chosen length of period does not imply the same liquidity premium as the intertemporal model because the appropriate length of the time period is asset specific.