Liquidity Premia and Transaction Costs

Standard literature concludes that transaction costs only have a second‐order effect on liquidity premia. We show that this conclusion depends crucially on the assumption of a constant investment opportunity set. In a regime‐switching model in which the investment opportunity set varies over time, we explicitly characterize the optimal consumption and investment strategy. In contrast to the standard literature, we find that transaction costs can have a first‐order effect on liquidity premia. However, with reasonably calibrated parameters, the presence of transaction costs still cannot fully explain the equity premium puzzle.