Equilibrium Returns with Transaction Costs

TL;DR

This paper develops a continuous-time model to analyze how transaction costs influence equilibrium returns, revealing that such costs induce mean reversion and higher expected returns under certain conditions.

Contribution

It introduces a tractable equilibrium model with quadratic transaction costs and derives explicit solutions, highlighting the impact of trading frictions on asset prices.

Findings

Equilibrium returns become mean-reverting due to transaction costs.

Expected returns increase when risk-averse agents are net sellers or asset supply grows.

Explicit solutions are obtained in various settings, illustrating the model's applicability.

Abstract

We study how trading costs are reflected in equilibrium returns. To this end, we develop a tractable continuous-time risk-sharing model, where heterogeneous mean-variance investors trade subject to a quadratic transaction cost. The corresponding equilibrium is characterized as the unique solution of a system of coupled but linear forward-backward stochastic differential equations. Explicit solutions are obtained in a number of concrete settings. The sluggishness of the frictional portfolios makes the corresponding equilibrium returns mean-reverting. Compared to the frictionless case, expected returns are higher if the more risk-averse agents are net sellers or if the asset supply expands over time.