Equilibrium interest rate and liquidity premium under proportional transactions costs

80 Pages·1992·2.7 MB·English

by  Vayanos, Dimitri

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WORKING PAPER
ALFRED SLOAN SCHOOL OF MANAGEMENT
P.
EQUILIBRIUM INTEREST RATE And
LIQUIDITY PREMIUM UNDER
PROPORTIONAL TRANSACTIONS COSTS
Dimitri Vayanos
and
Jean-Luc Vila
WP
#3508-92 December 1992
MASSACHUSETTS
INSTITUTE OF TECHNOLOGY
50 MEMORIAL DRIVE
CAMBRIDGE, MASSACHUSETTS 02139

EQUILIBRIUM INTEREST RATE And
LIQUIDITY PREMIUM UNDER
PROPORTIONAL TRANSACTIONS COSTS
Dimitri Vayanos
and
Jean-Luc Vila
WP
#3508-92 December 1992
Massachusetts Institute of Technology
First version: April 1992
This version: December 1992
•t^Avtititr'.
JAM 1 9 1993
2
Abstract
In this paperwe analyze the impact oftransactions costs on the rates ofreturn on liquid and illiquid
assets. We consider an infinite horizon economy with finitely lived agents along the lines of
Blanchard (1985). In this economy agents face a constant probability of death, and the population
is kept constant by an inflow of new arrivals. Agents start with no financial wealth and receive a
decreasingstream oflabor income over their lifetimes. In addition they can invest in long term assets
which pay a constant stream ofdividends. There are two such assets, the liquid asset and the illiquid
asset. The liquid asset is traded without transaction costs, while trading the illiquid asset entails
proportional transactions costs. Neither asset can be sold short. Agents buy and sell assets for life-
cycle motives. In fact, they accumulate the higher yielding illiquid asset for long term investment
purposes and the liquid asset for short term investment needs.
We find that when transactions costs increase, the rate ofreturn on the liquid asset decreases, while
the rate of return on the illiquid asset may increase or decrease. We also find, quite naturally, that
the liquidity premium increases. The effects oftransactions costs on the rate ofreturn on the liquid
asset and on the liquidity premium, are stronger the higher the fraction of the illiquid assets in the
economy. Finally, transactions costs have first order effects on asset returns and on the liquidity
premium.
We
evaluate these effects for reasonable parameter values.
Acknowledgments We would like to thank participants in the NBER Conference on Asset Pricing
:
in Philadelphia; participants at seminars at MTT, New York University and Wharton; Drew
Fudenberg, Mark Gertler, John Heaton and Jean Tirole for helpful comments and suggestions. We
alsowish to acknowledge financial support from the International Financial Services Research Center
at the Sloan School of Management. Errors are ours.