Asset Prices in General Equilibrium with Transactions Costs and Recursive Utility

In this paper, we study the effect of proportional transactions costs on asset prices and liquidity premia in a general equilibrium economy with multiple agents who are heterogeneous. The agents in our model have Epstein-Zin-Weil utility functions and can be heterogeneous with respect to endowments and all three characteristics of their utility functions – time preference, risk aversion, and elasticity of intertemporal substitution. The securities traded in the financial market include a one-period bond and multiple risky stocks. We show how the problem of identifying the equilibrium can be characterized in a recursive fashion even in the presence of transactions costs, which make markets incomplete. We find that transactions costs on stocks or the bond lead investors to reduce the magnitude of their positions in the two financial assets. The holding of each stock is very sensitive to its own transactions cost, but relatively insensitive to the transaction cost for the other stock. Transactions costs also reduce the frequency of trading of the stock; however, the effect on the frequency of trading the bond is much smaller. Our main finding is that even in the presence of non-tradable labor income, the effect of transactions costs on the liquidity premium and expected returns is significantly smaller in general equilibrium than in partial equilibrium: for a proportional transactions cost of 2%, the difference in the expected return on a stock that incurs this cost and one that does not is at most 0.20% in general equilibrium.