The effect of regime-switching transaction costs and cash dividends on liquidity premia

Abstract

We investigate the effect of the regime-switching transaction costs and dividends on liquidity premium and investor’s optimal strategy. With reasonably calibrated parameters, we show that counter-cyclical transaction costs substantially raise liquidity premium while pro-cyclical dividends amplify this effect. More importantly, we observe that cash dividends can no longer play a role as a liquidity provider if the volatility of pro-cyclical dividends increases. Our model provides a universal framework in the liquidity contexts, so that we can examine the effect of regime switching on liquidity premium for all combinations of regimes in transaction costs and dividends.