Market Closure , Liquidity Premia , and Return Predictability ∗

In his seminal work, Constantinides (1986) finds that transaction cost has only a second order effect on liquidity premia. In this paper, we show that incorporating the well-established time-varying return dynamics across trading and nontrading periods can produce a first order effect that is much greater than that found by the existing literature and comparable to empirical evidence. Surprisingly, the higher liquidity premium is Not from higher trading frequency, but mainly from the substantially “suboptimal” trading strategy chosen to control transaction costs. In addition, in contrast to the large literature on return predictability, we show that return predictability is not important in the presence of even small transaction costs. Furthermore, our model predicts that trading volume is greater at market close and market open than the rest of trading times. Journal of Economic Literature Classification Numbers: D11, D91, G11, C61.