Equilibrium Interest Rate and Liquidity Premium with Transaction Costs

In this paper we study the effects of transaction costs on asset prices. We assume an overlapping generations economy with two riskless assets. The first asset is liquid while the second asset carries proportional transaction costs. We show that agents buy the liquid asset for short-term investment and the illiquid asset for long-term investment. When transaction costs increase, the price of the liquid asset increases. The price of the illiquid asset decreases if the asset is in small supply, but may increase if the supply is large. These results have implications for the effects of transaction taxes and commission deregulation. ∗Vayanos: MIT Sloan School of Management, 50 Memorial Drive E52-437, Cambridge MA 02142-1347, tel 617-2532956, e-mail [email protected]. Vila: Convergence Asset Management, 475 Steamboat Road, Greenwich CT 06830, tel 203-8632000. We thank Darrell Duffie, Phil Dybvig, Mark Gertler, John Heaton, David Kreps, Jose Scheinkman, Costis Skiadas, and Jean Tirole, seminar participants at Berkeley, Ecole des Ponts, Georgetown University, MIT, New York University, Universitat Autonoma de Barcelona, University Carlos III, Washington University, and Wharton, and participants at the NBER Asset Pricing, Econometric Society, and Society of Economic Dynamics and Control conferences for very helpful comments. We also thank Minh Chau, Lee-Bath Nelson, and Muhamet Yildiz for excellent research assistance. The opinions expressed in this paper are the opinions of the authors only, and are not represented as being the opinions of Convergence Asset Management.