Transaction Costs and Asset Prices: A Dynamic Equilibrium Model

In this paper we study the effects of transaction costs on asset prices in an overlapping generations economy with a riskless and liquid bond and N risky stocks whose trading is subject to proportional costs. Quite surprisingly, the price of a stock does not always decrease in its transaction costs. In fact, the effect of transaction costs on the stock price is small than the present value of transaction costs incurred at intervals of size equal to the stock’s minimum holding period. We also find that a more frequently traded stock is not always more adversely affected by an increase in its transaction costs and that the price of a stock does not always increase when the transaction costs of a more liquid and correlated stock decrease. Our model is very tractable and closed-form solutions can be obtained.