Financial-market Equilibrium with Friction

We show that the endogenous stochastic process of the liquidity of securities is as important to investment and valuation as the exogenous stochastic process of their cash ‡ows. We develop a general-equilibrium model with heterogeneous investors who have an every-day motive to trade and pay transactions fees. Our model delivers the optimal, market-clearing moves of each investor and the resulting posted and transactions prices. We exhibit the e¤ect of transactions fees on deviations from the consumption CAPM. We compare expected returns on stocks carrying di¤erent fees and evaluate the ability of various empirical liquidity measures to act as pricing proxies. Previous versions circulated and presented under the title: “The Equilibrium Dynamics of Liquidity and Illiquid Asset Prices”. Buss is with INSEAD ([email protected]) and Dumas is with INSEAD, NBER and CEPR ([email protected]). Work on this topic was initiated while Dumas was at the University of Lausanne and Buss was at the University of Frankfurt. Dumas’research has been supported by the Swiss National Center for Competence in Research “FinRisk” and by grant #1112 of the INSEAD research fund. The authors are grateful for useful discussions to Beth Allen, Yakov Amihud, Laurent Barras, Sébastien Bétermier, Bruno Biais, Georgy Chabakauri, Massimiliano Croce, Magnus Dahlquist, Sanjiv Das, Xi Dong, Phil Dybvig, Thierry Foucault, Stefano Giglio, Francisco Gomes, Amit Goyal, Harald Hau, John Heaton, Terrence Hendershott, Julien Hugonnier, Elyès Jouini, Andrew Karolyi, David Lando, John Leahy, Francis Longsta¤, Abraham Lioui, Edith Liu, Hong Liu, Frédéric Malherbe, Alexander Michaelides, Pascal Maenhout, Stavros Panageas, LubošPástor, Paolo Pasquariello, Patrice Poncet, Tarun Ramadorai, Scott Richard, Barbara Rindi, Leonid Rosu, Olivier Scaillet, Norman Schürho¤, Raman Uppal, Dimitri Vayanos, Grigory Vilkov, Vish Viswanathan, Ingrid Werner, Fernando Zapatero and participants at workshops given at the Amsterdam Duisenberg School of Finance, INSEAD, the CEPR’s European Summer Symposium in Financial Markets at Gerzensee, the University of Cyprus, the University of Lausanne, Bocconi University, the European Finance Association meeting, the Duke-UNC Asset pricing workshop, the National Bank of Switzerland, the Adam Smith Asset Pricing workshop at Oxford University, the Yale University General Equilibrium workshop, the Center for Asset Pricing Research/Norwegian Finance Initiative Workshop at BI, the Indian School of Business summer camp, Boston University, Washington University in St Louis, ESSEC Business School, HEC Business School and McGill University.