Abstract
In contrast to empirical evidence, standard theories conclude that transaction costs only have a second order effect on liquidity premia. In this paper, we show that if one incorporates the well-established fact that market volatility during trading periods is significantly higher than during nontrading periods, then transaction costs have a first order effect that is much greater than that found by the existing literature and largely comparable to empirical findings. Surprisingly, the higher liquidity premium is Not from higher trading frequency, but mainly from the substantially suboptimal trading strategy. Extensive empirical analysis strongly supports our unique prediction that stocks with greater return variance variations across trading and nontrading periods require higher liquidity premia.
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