Optimal Portfolio Balancing Under Conventional Preferences and Transaction Costs Explains the Equity Premium Puzzle

Abstract

Following Constantinides' (1986) seminal approach and introducing transaction costs in the Pagano (1989) model, conventional CARA investors with heterogeneous endowments trade to construct optimal portfolios. We calibrate to the 1896-1994 equity and bond markets to show that gains from trade are high and, thus, investors require a high illiquidity premium even for a modest transactional charge. Excluding risk premia, exchange of equity and bonds by N strategic investors, as , under a mere 1% round-trip transaction cost induces a 6% illiquidity (equity) premium. Unlike existing literature, our findings are consistent with most stylized empirical facts. We recover the elasticity of trading demand from the excess equity return to confirm a major implication of the model. Among many other, so called, anomalies, we appear to explain the apparent irrational exuberance of equity markets, the 600% price premium for otherwise identical A stock over B stock in China, the low risk-free rate, the 20% letter stock premium and the lower return on the run bonds. Because illiquidity premia do not necessarily imply consumption volatility, variance bounds tests become irrelevant.