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Instantaneous Volatility and the Liquidity Premium

2011; RELX Group (Netherlands); Linguagem: Inglês

10.2139/ssrn.1914868

1556-5068

Thomas Leirvik,

Financial Markets and Investment Strategies

I investigate how transaction costs affect the optimal portfolio policy when volatility is stochastic. I find an analytical expression of the minimal size of the no trade region. This enables us to analyze the liquidity premium related to instantaneous volatility. I find the liquidity premium to be time dependent. With a finite investment horizon, the liquidity premium increases as the investment horizon approaches. I also find that the size of the liquidity premium is twice as large if the correlation between the stock returns and the volatility is zero. Contrary to findings in standard literature, I find that the risk aversion plays a significant role in determining the size of the liquidity premium. To the best of our knowledge, I am the first to analyze the impact of stochastic volatility on the liquidity premium. The results indicate that the transaction costs have a first-order effect on the liquidity premium.