Liquidity shocks and equilibrium liquidity premia. (Q1810698)

Transactions costs are the costs incurred in the trading of financial securities. The effect of such costs on stocks returns is quite high according to the empirical studies while the theoretical predictions are much smaller. For instance, the liquidity-premium coefficient (the ratio between the differential of expected returns and the differential of transactions costs of securities with similar cash flows but different transactions costs) ranges between \(1.5\) and \(2\) in the empirical studies but is less than \(0.5\) according to the theoretical estimates. The author points out that the main reason for such discrepancy is that the models have not yet given an explanation to the investors' high-frequency trading needs and, consequently, the observed high trading volume. He proposes a model where the investors do not control the liquidation time of their securities but instead it comes by surprise: a liquidity shock. Though the simplified conditions of the model (a continuous-time overlapping generations economy with two consol bonds, one liquid and one illiquid, and a continuum of agents with CRRA utilities) limits the scope of the conclusions, the results clearly show that when the investors face a random holding horizon due to liquidity shocks and they are constrained from borrowing against the future income, the premium for bearing the risk of the illiquid asset could be very high. Therefore, the paper successfully highlights the key role that liquidity shocks and borrowing constraints play in fitting in the observed holding horizons and liquidity premia of securities in the market.