Liquidity Shocks and Equilibrium Liquidity Premia
Posted: 5 Mar 1997
Date Written: September 1996
We study the impact of transaction costs on portfolio selection and equilibrium asset returns in an economy in which investors who face surprise liquidity shocks invest in liquid and illiquid riskless assets. We find that the portfolio policy and the equilibrium liquidity premium of investors who are well prepared for a liquidity shock are not, for small transaction costs, significantly different from those of investors with a fixed investment horizon. Investors who face constraints on borrowing against future income and have reserved little wealth against liquidity shocks, however, act as if they have a short investment horizon. The equilibrium liquidity premium for such investors can be significantly higher than that demanded by investors with a fixed investment horizon that is equal to the expected arrival time of a liquidity shock. This difference is due to the higher net return of the liquid asset, relative to that of the illiquid asset, in the case of an early liquidity shock (when investors have lower reserves and thus higher marginal utility). The liquidity premium is higher if agents are more risk-averse, and is higher if the liquid asset supply is smaller. We discuss the relevance of this result when one reconciles between market holding horizons and market liquidity premia.
JEL Classification: G12, G11
Suggested Citation: Suggested Citation