Continuous-time Equilibrium Returns in Markets with Price Impact and Transaction Costs

TL;DR

This paper models an Ito-financial market with endogenous returns influenced by strategic investors considering price impact and transaction costs, deriving equilibrium conditions and analyzing effects on returns.

Contribution

It introduces a comprehensive framework for equilibrium returns considering price impact and transaction costs, deriving explicit solutions and analyzing their effects.

Findings

Transaction costs do not affect equilibrium returns without noise traders.

Presence of noise traders amplifies the impact of transaction costs on returns.

Unique Nash equilibrium characterized by a system of FBSDEs.

Abstract

We consider an Ito-financial market at which the risky assets' returns are derived endogenously through a market-clearing condition amongst heterogeneous risk-averse investors with quadratic preferences and random endowments. Investors act strategically by taking into account the impact that their orders have on the assets' drift. A frictionless market and an one with quadratic transaction costs are analysed and compared. In the former, we derive the unique Nash equilibrium at which investors' demand processes reveal different hedging needs than their true ones, resulting in a deviation of the Nash equilibrium from its competitive counterpart. Under price impact and transaction costs, we characterize the Nash equilibrium as the (unique) solution of a system of FBSDEs and derive its closed-form expression. We furthermore show that under common risk aversion and absence of noise traders, transaction costs do not change the equilibrium returns. On the contrary, when noise traders are present, the effect of transaction costs on equilibrium returns is amplified due to price impact.