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A Short Note on the Tobin Tax: The Costs and Benefits of a Tax on Financial Transactions
July 2011

Raman Uppal

Professor of Finance, EDHEC Business School

Institute

Abstract
Almost each time volatility in equity, debt, or currency markets increases, there are cries to introduce a tax of financial transactions, first proposed in Tobin (1974). This tax is motivated by the view that the excess volatility in financial markets is the result of trading by speculators"; thus, even a small tax on financial transactions would "throw some sand in the wheels" of financial markets, and hence, by slowing down the trading activity of speculators would reduce volatility. In this article, we discuss the costs and benefits of such a tax on financial transactions.1

1 - Positions taken by hedge funds (for instance, the fund managed by George Soros) in currency markets were blamed for the devaluation of the British pound and the French franc in 1992-93. Speculators were also blamed for the crises in South-East Asian in 1997, in Russia in 1998, in Brazil in 1999, and Argentina in 2001. The high volatility in equity and credit markets during the recent financial crisis has also been blamed on the activities of speculators.

The work presented herein is a detailed summary of academic research conducted by EDHEC-Risk Institute. The opinions expressed are those of the authors. EDHEC-Risk Institute declines all reponsibility for any errors or omissions.

About the Author

Raman Uppal joined EDHEC Business School as Professor of Finance in 2011. He was formerly Professor of Finance and Chair of the Finance Subject Area at the London Business School, having previously worked at the University of British Columbia. He has held visiting positions at K.U. Leuven, MIT, and LSE, and has served as co-director of the Financial Economics Programme of the Centre for Economic Policy Research. His research focuses on optimal portfolio selection and asset allocation in dynamic environments, valuation of securities in capital markets, risk management, and exchange rates. He has published widely in leading journals such as Journal of Economic Theory, Journal of Finance, Journal of Financial and Quantitative Analysis, Management Science and Review of Financial Studies, and has received numerous grants and awards for his research work. He currently serves as editor for Journal of Banking and Finance and advisory editor for Review of Finance.

Table of Contents
Introduction ............................................................................................................................................ 5

1. What does theory tell us about the impact of a Tobin tax? .............................................. 6

2. What does the empirical evidence say about the impact of a Tobin tax? ........................ 7

3. Challenges in implementing a Tobin tax .................................................................................. 8

Conclusion .............................................................................................................................................. 9

Appendix ................................................................................................................................................ 11

References .............................................................................................................................................63

EDHEC-Risk Institute Position Papers and Publications (2008-2011) ....................................65

Introduction
In its budget proposal for the period 2014-2020, the European Commission has included a levy on financial transactions, more commonly known as a Tobin tax. The text, which was presented by the European Commission president Jos Manuel Barroso on June 29, 2011, envisages the introduction of this tax to fund around a third of its overall budget. The intention is for this tax, which was originally presented by the US economist James Tobin in the 1970s as a tool to combat financial speculation, but which has never been implemented, to contribute 50 billion per year to the European budget, or 350 billion over the seven-year period. It would amount to 0.01% of derivatives trades and up to 0.1% on exchanges of sovereign bonds. Foreign-exchange transactions would also be concerned. The overall European budget is projected to remain stable at around 1,000 billion between 2014 and 2020, but the European Commissions project will be the subject of negotiations between now and the end of 2012 with the European Council and the European Parliament. The levy on financial transactions is the subject of differing positions from the member states. Germany, France, Spain and other countries are in favour of it (members of the French national assembly even voted for a European resolution to introduce this tax on June 14 last). The United Kingdom, on the other hand, is firmly opposed to this project, which London believes would lead to financial activity being transferred from the City towards Asia or Switzerland. Moreover, the British Bankers Association warns that such a tax would end up being paid by bank customers rather than the banks themselves. The Economist (Stuck on Tobin Again, June 30, 2011) condemns Tobin taxes as unworkable (too easy to
5

avoid and likely to drive financial activity underground beyond regulatory oversight) and counterproductive (the reduction in liquidity would make asset prices more volatile).

1. What does theory tell us about the impact of a Tobin tax?

One way to understand the effect of a Tobin tax on volatility and welfare is to construct theoretical models of financial markets. In standard models with no market frictions and where all investors are rational, trading in financial markets only improves welfare by allowing investors to smooth consumption over time (that is, to save today in order to consume tomorrow), and to smooth consumption across states of nature (that is, by hedging or buying insurance). Therefore, in such a market, introducing a Tobin tax is not required, and if it were introduced, it would only distort incentives and reduce welfare. In order to motivate a role for the Tobin tax, theoretical models of financial markets introduce traders who are not fully rational (their irrationality may reflect overcondence or overly pessimistic or optimistic beliefs leading to suboptimal behavior); for an example of this kind of model, see Dumas, Kurshev and Uppal (2009). The trading in financial markets by such investors generates volatility that is in excess to the volatility generated by macroeconomic fundamentals. The objective of the Tobin tax is to reduce the impact of these traders on financial markets, and hence, curb excess volatility. The findings of theoretical models are mixed about the effectiveness of the Tobin tax to reduce volatility and improve welfare. The Tobin tax will obviously lead to a reduction in the trading of securities on which the tax is imposed. But, a reduction in the trading of financial securities also means that it is now more difficult to smooth consumption over time and across states of nature. The Tobin tax reduces speculative activity in financial markets; but, this tax also drives away investors who provide liquidity, stabilise prices, and help in the price discovery process. Thus, introducing a Tobin tax has both advantages (see,
6

for instance, Stiglitz and Summers and Summers) and disadvantages (see Ross, 1989), and the net effect on volatility is likely to be small, as shown in the model developed in Buss, Uppal and Vilkov (2011). Depending on the assumptions of the theoretical models, one can get very different conclusions about the implications of a Tobin tax. Thus, theoretical models are not sufficient to resolve the debate about the appropriateness of a Tobin tax, and hence, one must consider the empirical evidence.

2. What does the empirical evidence say about the impact of a Tobin tax?
There is a substantial body of empirical work studying the effect of a transactions tax on volatility of the price of financial securities. Most of these find that a transaction cost either fails to reduce return volatility, or leads to an increase in volatility. For example, Roll (1989) examines volatility of stock returns in over 20 countries during the period 1987 to 1989 and finds no evidence that volatility is related to a Tobin tax. Saporta and Kan (1997) find a similar result for the United Kingdom. Umlauf (1993) investigates stock returns in Sweden over the period 1980 to 1987 and finds that the increase in the transaction tax by one percent in 1986 leads to an increase in volatility. Bessembinder and Rath (2002) find that stocks that move from NASDAQ to NYSE, where trading costs are lower, see a reduction in volatility. Similarly, Hau (2006) finds that when there is an increase in the cost for trading stocks in France, these stocks see a significant increase in volatility. Aliber, Chowdhry, and Yan (2003) study the imposition of a Tobin tax in currency markets and finds that it leads to an increase in volatility. Moreover, the imposition of a transaction tax leads to a reduction in the demand for that financial security, and thus, a drop in its price.

3. Challenges in implementing a Tobin tax

Imposing a tax on financial transactions presents its own challenges. For example, can regulators really distinguish between transactions related to fundamental business and those that are purely speculative? Can regulators determine the appropriate rate for the Tobin tax that would reduce the activities of investors who are not fully rational but not drive away trade by rational investors? And, from the point of view of speculators, unless every country in the world introduced the Tobin tax, it would be easy to circumvent the tax by routing transactions through countries that do not impose the tax. Similarly, unless every security was taxed, one could circumvent the tax by using derivatives.

Conclusion
In conclusion, the theoretical arguments in support of the Tobin tax as a measure to reduce volatility are, at best, mixed; the empirical evidence, on the other hand, indicates that a Tobin tax has either no effect on volatility or it actually increases volatility; and, introducing a Tobin tax faces serious implementation challenges. Thus, while free" financial markets may not be the best solution, a Tobin tax is unlikely to be the correct medicine for the negative effects that arise from the trading in financial markets by investors who are not fully rational.

References
Aliber, R.Z., B. Chowdhry, S. Yan, 2003, Some Evidence That a Tobin Tax on Foreign Exchange Transactions May Increase Volatility, European Finance Review 7, 481-510. Bessembinder, H. and S. Rath, 2002, Trading Costs and Return Volatility: Evidence from Exchange Listings, Working Paper, University of Utah. Buss, A., R. Uppal, and G. Vilkov, 2011, Asset Prices in General Equilibrium with Transactions Costs and Recursive Utility, Working Paper, EDHEC and Goethe University, Frankfurt. Dumas, B., A. Kurshev and R. Uppal, 2009, Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility," Journal of Finance 64.2, 579-629. Hau, H., 2006, The Role of Transaction Costs for Financial Volatility: Evidence from the Paris Bourse, Journal of the European Economic Association 4.4, 862-890. Roll, R., 1989, Price Volatility, International Market Links, and Their Implications for Regulatory Policies, Journal of Financial Services Research 3.2-3, 211-246. Ross, S., 1989, Commentary [on Stiglitz 1989], Journal of Financial Services Research 3, 117-120. Saporta, V. and Kan, K., 1997, The Effects of Stamp Duty on the Level and Volatility of Equity Prices, Bank of England Working Paper No 71. Stiglitz, J., 1989, Using Tax Policy to Curb Speculative Trading, Journal of Financial Services Research 3, 101-115. Summers, L. and V. Summers, 1989, When Financial Markets Work Too Well: A Cautious Case For a Securities Transactions Tax, Journal of Financial Services Research 3, 261-286. Tobin, J., 1978, A Proposal for International Monetary Reform, The Eastern Economic Journal 4.3-4, 153-159. Umlauf, S.R., 1993, Transaction Taxes and the Behavior of the Swedish Stock Market, Journal of Financial Economics 33.2, 227-240.

10

Appendix Asset Prices in General Equilibrium with Transactions Costs and Recursive Utility
Adrian Buss, Goethe University Frankfurt, Finance Department Raman Uppal, CEPR and EDHEC Business School Grigory Vilkov, Goethe University Frankfurt, Finance Department April, 2011 Keywords: general equilibrium, incomplete market, transaction costs JEL: G11, G12 We acknowledge suggestions from Bernard Dumas. We received helpful comments and suggestions from seminar participants at Goethe University Frankfurt and University of Zrich.

Abstract
In this paper, we study the effect of proportional transactions costs on asset prices in a general equilibrium economy with multiple agents who are heterogeneous. The agents in our model have Epstein-Zin-Weil utility functions and can be heterogeneous with respect to endowments, beliefs, and all three characteristics of their utility functions time preference, risk aversion, and elasticity of intertemporal substitution. The securities traded in the financial market include a long maturity discount bond and multiple risky stocks. We show how the problem of identifying the equilibrium can be characterized in a recursive fashion even in the presence of transactions costs, which make markets incomplete. We then study the effect of transactions costs on the interest rate, the stock price, the expected return and risk premium on stocks, and the volatility of stock and bond returns. We find that transactions costs on either the stock or the bond lead investors to reduce the magnitude of their positions in the two financial assets. Transactions costs also reduce the frequency of trading of the stock. However, the effect on the frequency of trading the bond is much smaller; for even large transactions costs in the bond market, the investors continue to trade the bond. Transactions costs make it less attractive to hold financial assets, and therefore, lead to a reduction in the prices of assets. The expected return on the bond increases with transactions costs. The effect on the volatility of bond returns, however, depends on preferences; as we increase transactions costs on the stock, the volatility of bond returns increases for the case of power utility but decreases for the case of Epstein-Zin preferences. When there are two stocks, we find that the holding of each stock is very sensitive
11

Appendix
to its own transactions cost, but relatively insensitive to the transaction cost for the other stock. prices of assets. For example, increasing the cost of trading the stock from 10 to 200 basis points leads to a drop of about 2% in the price of the stock and 3% in the price of the bond. The expected return on the bond increases with transactions costs. The effect on the volatility of bond returns, however, depends on preferences; as we increase transactions costs on the stock, the volatility of bond returns increases for the case of power utility but decreases for the case of Epstein-Zin preferences. Note that the two investors do not trade the stock at each date, and hence, may not agree on the return characteristics of the stock. We nd that for moderate levels of transactions costs, the equity risk premium and Sharpe ratio increase with transactions costs for both investors. When there are two stocks, we find that the holding of each stock is very sensitive to its own transactions cost, but relatively insensitive to the transaction cost for the other stock. And, as one increases the transactions costs on either stock, the magnitude of bond holding declines because of the decrease in the holding of the stock whose transaction cost has increased. As one would expect, when there are two stocks, agents use the stock with the lower transactions cost to share risk and smooth consumption over time. Asset prices respond to the changes in demands described above. That is, an increase in the transaction cost of a particular stock leads to a decrease in the price of the stock and the bond, but has only a small effect on the price of the other stock. The paper in the existing literature that is closest to our work is Vayanos (1998). Similar to our model, Vayanos also studies a model with multiple stocks in the presence of transactions costs. One of the strengths of his paper that the model has a closed-form solution, which can be

1. Introduction
Our objective in this paper is to study the effect of proportional transactions costs on asset prices in a general equilibrium economy with multiple agents who are heterogeneous. The agents in our model have recursive utility functions and can be heterogeneous with respect to endowments, beliefs, and all three characteristics of their utility functions time preference, risk aversion, and elasticity of intertemporal substitution. We consider a financial market in which the traded securities consist of a long maturity discount bond and multiple risky stocks, and these securities, even in the absence of transactions costs, may not be sufficient to span the market for instance, if agents have nontraded labor income. We show how the problem of identifying equilibrium in this incompletemarkets economy can be characterized in a recursive fashion even in the presence of costs for transacting in stocks and bonds. We then study the effect of transactions costs on the interest rate, the stock price, the expected return and risk premium on the stock, and the volatility of stock and bond returns. Our main results are summarized below. We find that transactions costs on either the stock or the bond lead investors to reduce the magnitude of their positions in the two financial assets. Transactions costs also reduce the frequency of trading of the stock. However, the effect on the frequency of trading the bond is much smaller; for even large transactions costs in the bond market, the investors continue to trade the bond. Transactions costs make it less attractive to hold financial assets, and therefore, lead to a reduction in the
12

Appendix
used to obtain several interesting insights. However, to obtain a closed-form solution, several restrictive assumptions need to be made: the interest rate is assumed to be exogenous and constant, which can have an important bearing on results, as shown by Loewenstein and Willard (2006); agents are assumed to have exponential utility functions, which do not allow for the study of wealth effects; dividends follow an Ornstein-Uhlenbeck, so they are normal, instead of being lognormal; transactions costs are proportional to the number of shares rather than the value of shares, as is typically the case in financial markets; the model is one of overlappinggenerations, with risk aversion increasing with age; and, it is assumed (in his Section 5) that the shortsale constraint is binding. A consequence of these assumptions is that stock prices are linear in dividends, and the stock holdings of agents are deterministic. In contrast to these modeling assumptions, we allow for an endogenous interest rate, recursive utility functions (which nest exponential utility as a special case), a process for dividends that is not restricted to be normal, proportional transactions costs that depend on the value of shares traded, and agents who can be heterogeneous with respect to their endowments, beliefs, and/or preferences. There are several other papers in the literature that also study the effect of transactions costs on asset prices. Amihud and Mendelson (1986) study a generalequilibrium model in which agents are risk-neutral and must exit the market at which time they sell stock to newly arriving agents; they find that the excess return on a stock equals the product of the asset's turnover and the proportional transaction cost. Constantinides (1986) shows that because the agent chooses when to trade optimally, the effect of transactions costs on asset prices is much smaller than suggested by Amihud and Mendelson. Vayanos (1998) considers an overlappinggenerations model with multiple stocks and also nds that transactions costs have a small impact on prices. Heaton and Lucas (1996) consider a model where heterogeneity across agents arises because of idiosyncratic labor income shocks. Financial markets have only one stock and a one-period bond, with transactions costs for both the stock and bond. They find that it is important to have transactions costs also for the bond, otherwise the agent just switches to trading the bond. In their model, there is a spread between the borrowing and lending rates and there are quadratic transaction costs for trading the stock.1 There are also constraints on shortselling and borrowing. They study the effect of transactions costs on the equity premium and decompose it into two parts. The direct effect occurs because individuals equate marginal values net of transactions costs. The indirect effect occurs because of the decrease in risk sharing, which makes individual consumption tracks individual income more closely. They find that the direct effect is the dominant one, and that the model can produce a sizable equity premium only if transactions costs are large or the assumed quantity of tradable assets is limited. Lo, Mamaysky, and Wang (2004) consider a general-equilibrium setting with fixed transaction costs and high-frequency transaction needs; they find that the effect of transactions costs in such a setting is larger, and of the same order as the transaction costs. Just like in Vayanos (1998), this paper also assumes a constant (exogenous) interest rate and exponential utility, but in contrast to Vayanos (1998), this paper considers xed transactions costs for stocks and no transactions costs for
13
1 - Heaton and Lucas (1996, Equation (19), p. 467) also consider a specication where the transaction cost function is quadratic for small transactions and linear for larger transactions.

Appendix
bonds. The motivation for trading in the model is heterogeneous nontraded (labor) income, which in aggregate sums to zero; that is, there is no aggregate risk. Moreover, it is assumed that the risk in the nontraded asset is perfectly correlated with the stock, which implies that the non-traded income is marketed. These assumptions allow one to get a closed-form solution for the special case where agents can trade at only the first date or for the case where transactions costs are small. Our paper makes two contributions relative to the existing literature. One, it generalizes the results in the literature on asset prices and transactions costs: in particular, the model we study allows for an endogenous interest rate, recursive utility functions, and agents who are heterogeneous with respect to their endowments, beliefs, and/ or preferences. The second contribution of our paper is on the methodological front. We demonstrate how one can identify the equilibrium in an economy where there are heterogeneous agents who have recursive utility, even in the presence of transactions costs and incomplete nancial markets. In contrast to our work, Dumas, Uppal, and Wang (2000) show how to characterize equilibrium in a setting with multiple agents who have recursive utility but where financial markets are complete. Dumas and Lyaso (2010) consider the setting where agents have time-additive utility functions and there are insucient number of securities to span the market, but do not allow for recursive utility and transactions costs. Lucas (1994) and Telmer (1993) examine asset prices in a model with agents who have time-additive utility functions and transitory idiosyncratic income shocks while Constantinides and Due (1996) look at the case of permanent idiosyncratic shocks; but these models do not have
14

trading costs. Heaton and Lucas (1996) allow for both transitory and permanent income shocks in the presence of quadratic transactions costs; we also allow for both transitory and permanent income shocks, but consider proportional transactions costs in the presence of multiple risky assets and recursive utility functions. Our work also extends to a general equilibrium setting the large literature that examines portfolio choice with transactions costs in a partial equilibrium setting.2 There is also a large literature studying the effect of liquidity on asset prices, but in contrast to this literature, we choose to focus on the effect of trading costs on asset prices. The rest of the paper is organized as follows. In Section 2, we describe the general model. In Section 3, we characterize the equilibrium and explain how it can be described by a system of backward-only (recursive) equations instead of a system of backward-forward equations.

2. The General Model

In this section, we describe the features of the model we study. In our model, there is a single consumption good. Time is assumed to be discrete. We denote time by t, with the first date being t = 0 and the terminal date being t = T. In our model we will allow for K = 2 agents, who are indexed by k and who have recursive utility functions. We assume that there are multiple sources of uncertainty, with the number of sources of uncertainty denoted by M. There are N + 1 risky assets that are indexed by n = {0, 1, , N}, where the first asset, n = 0, is assumed to be a long-lived bond that delivers one unit of consumption at date T and has zero dividends for t < T; the remaining N assets are assumed to be stocks. We allow for the possibility of that the number of risky assets traded in financial markets, is less than the number

2 - See, for instance, Davis and Norman (1990), Due and Sun (1990), Dumas and Luciano (1991), Gennotte and Jung (1994), Atkinson and Wilmott (1995), Morton and Pliska (1995), Korn (1998), Schroder (1998), Balduzzi and Lynch (1999), Lynch and Balduzzi (2000), Akian, Sulem, and Taksar (2001), Liu and Loewenstein (2002), Liu (2004), and Muthuraman and Kumar (2006).

Appendix
of sources of uncertainty, that is, N M. The main feature of our model is that there is a proportional transactions cost for trading financial assets. We allow for transactions costs on both the bond and the N stocks, with the possibility that these transactions costs are different for different assets.3 We are interested in examining the eect of the transactions costs on the trading of financial assets by the two agents, and the effect of this on the properties of asset prices. In the rest of this section, we give the details of the model. supply that pays zero dividends for t < T and pays one unit of consumption on the terminal date. The other N stocks are assumed to be in unit supply and have a dividend d(n, t, ), which is assumed to be t measurable. Aggregate dividends at any node are then given by . The ex-dividend prices of these assets, S(n, k, t), are determined in equilibrium; note that in the presence of transactions costs, agents may choose not to trade a particular asset at a particular date, in which case agents will not agree on the price of this asset: S(n, 1, t) S(n, 2, t). The ex-divided price on the terminal date for these assets is zero. In the special case where one assumes M = N, then each component of the multinomial process could be interpreted as the exogenous dividend from the nth tree." In the general case where M > N, one could interpret N components of the multinomial process as the exogenous dividends for the N trees, and the remaining M - N processes as labor income received by the agents. Shares of a particular asset n held by investor k at date t are denoted by (n, k, t).

2.1 Uncertainty Time is assumed to be discrete, with t = {0, 1, , T}. Uncertainty is represented by a -algebra on the set of states . The filtration denotes the collection of -algebras t such that t s; s > t, with the standard assumptions that 0 = {, } and t = . In addition to time being discrete, we will also assume that the set of states is finite, and so the filtration can be represented by a tree, with each node on the tree representing a particular state of nature, (t, s). The probability measure on this space is represented by P : -> [0, 1] with the usual properties that P() = 0, P() = 1 and for a set of disjoint events Ai we have that .
In our implementation of the model, we will assume that uncertainty is generated by a M-dimensional multinomial process, as described in He (1990), which is an extension of the binomial process that is often used for pricing options in a discretetime and discrete-state framework (see Cox, Ross, and Rubinstein (1979)).4

2.2 Financial assets We assume that there are N + 1 assets that are traded in financial markets. The first asset is a discount bond in zero net

2.3 Preferences We assume that the preferences of agents are of the Kreps and Porteus (1978) type. These utility functions nest the more standard constant relative risk aversion power utility functions but have the wellknown advantage that the risk aversion parameter, which drives the desire to smooth consumption over states of nature, is distinct from the elasticity of intertemporal substitution parameter, which drives the desire to smooth consumption over time. We adopt the Epstein and Zin (1989) and Weil (1990) specification of this utility function, in which lifetime expected utility V (k, t) is defined recursively:
15

3 - The transactions costs could dier also across agents. 4 - Given that we allow for incomplete nancial markets, the exact process used to generate uncertainty could be more general; for instance, we could allow for jumps.

Appendix
in (1) by choosing consumption, c(k, t) and the portfolio positions in each of the financial assets, (n, k, t), n = {0, 1,, N}. This optimization is subject to a dynamic budget constraint. For expositional ease, we explain the case where M = N and the agents have no labor income.8 For this case, the budget constraint is:

(1) In the above specification, Et denotes the conditional expectation at t, c(k, t) > 0 is the consumption of agent k at date t in state (t, s),5 k is the subjective rate of time preference, k > 0 is the coefficient of relative risk aversion, > 0 is the elasticity of intertemporal substitution, and . The above specification reduces to the case of constant relative risk aversion if k = 1, which occurs when = 1/k. The index k for the parameters k, k, and indicates that the agents may differ along all three dimensions of their utility functions.6

(2) where the left-hand side of the above equation is the amount of wealth allocated to consumption and the purchase of shares at date t, and the right-hand is the shares purchased at date t 1 valued at the prices prevailing at date t, which can be interpreted as the investor's wealth at t. We assume that each agent is endowed with some shares of the risky assets at the start of time. Note that in the above formulation we have not imposed constraints on short selling or borrowing; if one wished, these constraints could be imposed on the trading strategy of the agent. Thus, the Lagrangian for the optimization problem in (1) subject to the (2) is:

2.4 Transactions costs We assume that agents pay a proportional cost for trading financial assets. The transaction cost at t depends on the value of shares being traded.7 We denote this transaction cost by ). We assume that this is a deadweight cost for making a transaction, and hence, this amount does not flow to any agent.

3. Characterization of Equilibrium
In this section, we first describe the optimization problem of each agent. We then impose market clearing to obtain a characterization of equilibrium, which is given in terms of a backward-forward system of equations. Finally, we show how this backward-forward system of equations can be transformed into a recursive (backward-only) system of equations.

3.1 The optimization problem of each agent The objective of each investor k is to maximize lifetime expected utility given
16
5 6 7 8 Throughout the paper, we will not write explicitly the dependence on the state (t, s). One could also allow for differences in beliefs, but for now we assume that all agents take expectations using the correct probability measure. We also consider the case where the transaction cost depends on the number of shares being traded, which is the specification studied in Vayanos (1998). Note that because of the presence of transactions costs nancial markets are incomplete even for the case in which M = N.

(3)

Appendix
where (k, t) is the Lagrange multiplier for the dynamic budget constraint. Equation (5) is simply the budget constraint that the optimal consumption and portfolio policies must satisfy. Equation (6) is the first order condition for consumption and it equates the marginal utility of consumption to (k, t), the shadow price for relaxing the budget constraint. Equation (7) equates the benefit from holding the stock for versus selling the stock, net of transactions costs. The solution of the problem in (1) subject to the budget constraint in (2) is characterized by the system of equations given in (5), (6), and (7), which must hold for each date and state on the tree. One can substitute for (k, t) in Equation (7) using Equation (6). After this substitution, we need to solve only for optimal consumption and the optimal portfolio at each node.

3.2 Equilibrium in the Economy Equilibrium in this economy is defined as a set of consumption policies, c(k, t) and portfolio policies, (n, k, t), along with the resulting price processes for the financial assets, S(n, k, t) such that the consumption policy of each agent maximizes her lifetime expected utility; that this consumption policy is financed by the optimal portfolio policy; financial markets clear so that and , and the market for the consumption good clears,

(4) Based on the above Lagrangian, the firstorder conditions with respect to (k, t), c(k, t), and (n, k, t) are:

(5)

(6)

(7)

3.3 Recursive Characterization of the Equilibrium The equations characterizing the equilibrium can be solved simultaneously for all agents in all states of nature (t, s), or one can come up with a recursive formulation that allows us to solve for an equilibrium backwards, one period at a time. For the recursive formulation of an agent's utility maximization problem we define for each time t the value function that represents the maximum utility of the agent from time t onwards as a function of input parameters subject to the budget and other general equilibriumspecific constraints. In a problem without transaction costs the value function is typically a function of the agent's wealth at time t, given by the right-hand side of equation (2). In the presence of transaction costs, the entering wealth of an agent does not contain all the information required to optimize the utility from time t onwards we need to know also the portfolio
17

Appendix
composition at time t 1 to compute the left-hand side of the budget equation (2) after we solve for the current portfolio weights. The reason for this is that because of transactions costs, the decision on what portfolio to hold will depend on the current composition of the portfolio. (10) We define the value function J(k, t) as a function of past portfolio holdings (n, k, t 1): In addition to the above, for the equilibrium we need the conditions for the financial and consumption-good markets to clear: (11)

(8) (12) and we solve at each point in time the dynamic program subject to the budget constraint (2), where we optimize with respect to the current consumption and portfolio holdings only, assuming that in the future the agent behaves optimally. We show in the appendix that the principle of the dynamic programming applies to the problem with transaction costs, i.e., the maximization goal of an investor k at time 0 is achieved if and only if the value function J(k, t) is maximized at all times and states.9 Forming the Lagrangian, taking the first order conditions, and applying the envelope theorem, we obtain the same set of equations that we need to solve at each state for each agent, but now these can be solved recursively, i.e., starting from the last time period T and working backwards:

(13) There are two problems one faces in solving this system of equations. The first problem is that the current consumption and portfolio choices depend on the prices of assets, which from Equation (10) we see depend on future consumption. This is what makes it difficult to solve the system of equations in a recursive fashion because when the agent attempts to solve for the optimal consumption and portfolio policies at date t one needs asset prices to change in order for markets to clear, but these prices depend on future consumption which would have already been determined if one were solving the system of equations backward. This is why to obtain the solution must iterate backwards and forwards until the equations for all the nodes on the tree are satisfied. Dumas and Lyaso (2010) propose a method that allows one to write

(9)
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9 - In short, we show that the first-order conditions of the dynamic program is equivalent to the first order conditions (5), (6), (7); moreover, one can also show that the value function is concave, i.e., satisfying the first-order conditions of the dynamic program is necessary and sufficient.

Appendix
the system so that it is recursive in order to overcome this problem. The second problem arises because of transactions costs. If agents choose to trade, then for the case where M = N nancial markets span the uncertainty. However, if agents find it optimal not to trade some of the assets, then markets are effectively incomplete, and agents will disagree on asset prices at that node. Consequently, the number of unknowns to be solved for, and the system of equations characterizing the solution, depends on whether or not agents choose to trade all assets or only some of the assets. Below, explain in detail how we resolve these two problems by extending the Dumas and Lyaso (2010) method in order to obtain a recursive system of equations even in the presence of transactions costs. decisions of the investor in the parent state at time T 2, i.e., in (T 2, s). Our solution is also linked to all states at the next date T through the condition (10), because the choice of future consumption aects the marginal rate of substitution, and hence, asset prices today. When we are solving the system at date T 1, this is not a problemwe do not make any decisions at T and our choices are determined by the boundary conditions. However, as we go further backwards in time, this dependency becomes an obstacle. To illustrate this, imagine that we are solving the system at time t using the incoming wealth of each investor k, i.e., , as the state variable. As a result, we find the optimal consumption c(k, T) and portfolio holdings (n, k, T) as functions of the incoming wealth W(k, t). Going to time t 1, we again solve the system (9) and (10) in order to infer the optimal consumption c(k, T 1) and portfolio holdings (n, k, T 1) as a function of incoming wealth W(k, t1). The choice of portfolio holdings (n, k, T 1) affects the wealth level W(k, t) and through it the optimal consumption at time t. In its turn, the optimal consumption at time t affects the asset prices and hence also the wealth at time t 1. While the solution at time t 1 also depends on the optimal values at t 2 through the incoming wealth, we get three periods in time linked and as a result cannot simply solve the problem going backwards. Instead, we iterate backwards and forwards until we converge to a solution. To address this problem, we use the method proposed in Dumas and Lyaso (2010), to change the system of equations in a way that allows us to go backwards through the whole tree at once, without any forward iterations, and then to go forward through the whole tree only once after we reach
19

3.4 From Forward-Backward to Backward-Only System of Equations To illustrate the resolution of the first problem, we simplify the setup initially by assuming that the transaction costs are zero. As a result, in the recursive system of equations (9)-(13) all terms with the transaction costs function (.) and its derivatives vanish.
We start solving the system at time T with the known boundary conditionsthe asset prices become nil after delivering their the last payment (dividend for the risky assets or the bond value for the risky bond), and the agents consume everything they get from their portfolio at the beginning of the period. Going backward to the parent state (T 1, s), we need to solve for the current consumption c(k, T 1) and portfolio holdings (n, k, T 1). Observe from the budget equation (9) that our current solution will be affected by the investment

Appendix
the initial date t = 0. To accomplish this transformation, we perform a time shift," where at each state (t, s) we form a new system of equations including in it the original equation (10) from a given state (t, s), and all other equations from the states directly following the current one, i.e. from (t + 1, s +). In particular, the rst two equations (9) and (10) from above become: anymore. We move to period T 2, solve for the optimal consumption c(k, T 1) and optimal portfolio investments (n, k, T 2). The solution at time T 1 is derived as a function of c(k, T 1), and the variables from T 1 entering the equations (14), (15), and the market clearing conditions are routinely computed for a given value of c(k, T 1). We keep moving backwards until we reach the starting point t = 0. Counting the equations at each node, we can see that we have solved all the equations necessary to characterize the equilibrium, except for the budget equation (14) and market clearing conditions for time t = 0. Now we perform the forward step by solving these two remaining sets of equations

(14)

(15) The market clearing conditions (11) to (13) are written for the t + 1, but as they affect only one period at a time, we omit them for space reasons. We solve the time-shifted system at each state (t, s) for the optimal consumption at time t+1 and the optimal portfolio investments at time t, i.e., c(k, T + 1) and (n, k, t) as functions of the current consumption c(k, t). We start working backwards at time T 1, and solve for the current portfolio holdings (n, k, t), knowing from the boundary condition that the future consumption c(k, t) is equal to the final portfolio payout. Future portfolio holdings at T are also known from boundary conditions. Knowing the future consumption, we also compute the asset prices at T 1 as a function of the state variable c(k, T 1). Note that due to the time shift, the budget equation (14) is not affected by any variables from the past, and hence the past decision does not affect the current investor behavior
20

(16)

(17)

(18)

(19) using as initial conditions the known starting portfolio positions (n, k, 1) before the initial trading date at t = 0. We then move forward through the whole tree and find the equilibrium solution (consumption and portfolio investment) for all states of nature (t, s).

3.5 Dealing with the Transaction Costs We now introduce transaction costs into the time-shifted system of equations.

Appendix
While in the absence of transaction costs the solution looks straightforward, mostly due to the "time shift", the presence of transactions costs complicates the problem for two reasons. First, as noted above, proportional transaction costs give a rise to a no-trade region," where the agents can disagree on the prices of the traded assets, and we cannot use in the solution the kernel condition," arising from the equivalence of prices in equilibrium as seen by different investors. Second, the transactions costs re-establish an explicit link between the portfolio decision at date t and the past portfolio investment at date t 1 by entering the equilibrium conditions: using the current consumption at t as a state variable, we also use the asset holdings at the past period (n, k, t 1) as additional state variables. Note that the past portfolio holdings enter the system of equations only though the condition (21) as a first partial derivative of the transaction cost function (.) with respect to the current portfolio investment. Moreover, because of the assumption that the transaction costs are a constant proportion n of the value of an asset n being traded, there are only three possibilities for the form of this derivative. It is equal to zero when an agent decides not to trade; to when the agent decides to increase his position in the asset; or, to when the agent sells the asset. All the (n, k, t 1) values for which the agent decides to buy an asset at time t result in the same solution (n, k, t) for a given value of current consumption c(k, t). Similarly, all (n, k, t 1) values for which the agent decides to sell an asset at t result in the same solution (n, k, t) for a given value of current consumption. And all other values of past portfolio holdings will result in no trading at t. In other words, instead of solving the problem over the wide (difficult-to-determine) grid of portfolio holdings at t 1, we can solve it first for the two trading decisions sell or buy at time t; that is, over the two values of the derivative of the transaction cost function. This solution provides us with the bounds of the no-trade region, for which the portfolio investment from t 1 to t does not change. Knowing the bounds of the no-trade region, we solve the system of equations for the future consumption c(k, t + 1 only, explicitly restricting current portfolio holdings within these no-trade bounds to be equal to the past portfolio holdings (n, k, t 1). It is important to recognize that within the no-trade bounds the agents can disagree on the prices of the traded assets, and hence we
21

(20)

(21) The transaction costs function is present also in the market-clearing condition for consumption good (because part of the endowment is now wasted on transactions costs if trade occurs), but there it affects only one period, and we omit it for now. We extend the Dumas and Lyaso (2010) method to deal with these two complications. As before, we solve the time-shifted system of equations for each t, but in addition to

Appendix
lose thekernel" condition equating these prices in equilibrium. In this way we are able to solve the system recursively in a backward fashion, knowing for each set of values of state variables if we are currently facing a no-trade region with a smaller number of equations to be solved for consumption only, or the full set of equations to be solved for consumption and the investment portfolio. After we solve the dynamic program recursively up to time t = 0, we perform again the forward step computation to determine the equilibrium quantities for each state of nature, given the initial conditions.

4.1 One Risky Asset We first consider the case where the asset menu available to the two agents consists of a bond and a single stock; one can imagine this to be the case where the investor has to allocate assets between a long-term risk-free bond, and the market portfolio.
4.1.1 Portfolio Holdings and Trading Behavior In Tables 1 and 2, and in Figures 1 and 2, we present the portfolio holdings of the first agent at the initial node of tree. As expected, the agents' holdings in the stock are a decreasing function of the stock's transaction costs. That is, higher transaction costs imply a less extreme position in the stock. Consequently, the first, less risk-averse, agent also borrows less from the second, more risk-averse, agent and so the bond position is also less extreme. For instance for Setup 3, when we increase the transaction cost from 10 basis points to 200 basis points, the stock holding decreases from 0.71 to 0.65, a decrease of about 9%, and similarly the bond holding changes from 0:90 to 0:66. Similarly, for a given level of transactions cost for the stock, the presence of transactions cost on the bond causes the agents to take less extreme positions in nancial assets. To understand the trading behavior of the two agents over the full horizon of the economy, we present in Tables 3 and 4, and in Figures 3 and 4 the number of nodes at which the agents trade. In total there are 15 possible node where the agents may trade. The agents always trade the bond independent of the level of transaction costs on the bond and stock. However, for the stock we see a rather strong deviation from the optimal behavior in absence of transaction costs where agents would always trade. That is, for transaction costs of 100 basis points on the stock the agents

4. Implications of Transaction Costs for Asset Prices

To study the quantitative implications of our model, we use the following parameter values. We assume that the economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods; that is, t ranges from 0 to 5. For the dividend dynamics of the stocks we assume that the expected return = 0.08 and the volatility = 0.15. In case of two available risky assets we assume a dividend correlation of 0.25. For the stocks, we vary the transaction costs from 10 basis points to 200 basis points whereas the transaction costs on the bond are either set to zero or to 10 basis points. We consider three setups in terms of the preferences of the agents: Setup 1 has two agents with power utility with relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5; Setup 2 has two agents with Epstein-Zin preferences, each having the same RRA, 1 = 2 = 5, and elasticity of intertemporal substitution (EIS) equal to = 0.50; and, Setup 3 has two agents with Epstein-Zin preferences, each having the same RRA, 1 = 2 = 5, and EIS equal to = 1.50.
22

Appendix
only trade at 56 nodes in the tree; that is, at about 1/3 of the available nodes. This also implies that the agents will often not agree on the price of the stock but have different private valuations. In contrast to this, the agents will always agree on the price of the bond. 4.1.2 Asset Prices The prices of the two available assets are presented in Tables 5 and 6, and in Figures 5 and 6. Note from the results in the preceding section that the agents always trade the bond and the stock at the initial node. Therefore, at t = 0 the agents agree on the prices of both assets and so we report their common valuations. We observe a similar pattern for the prices of both assets, across the different preference setups as well as for the various transaction costs combinations: the prices of the assets are decreasing in the level of transaction costs for both the bond and the stock transaction. Increasing transaction costs for the stock from 10 basis points to 200 basis points decreases the price of the bond and the stock by about 2% and 3%, respectively. These effects are a bit stronger in the presence of transaction costs on the bond. These price effects are driven by three key determinants: First, the agents have to pay transaction costs which reduces their consumption levels and therefore alters the pricing kernels. Second, due to the presence of the transaction costs, agents portfolio holdings differ from the zero transaction costs holdings (the "Merton line") and accordingly the consumption levels differ and also the pricing kernels. Third, the fact that the agents hold less extreme positions, reduces the demand for the assets. 4.1.3 Return Characteristics The changes in the assets' prices also have an impact on the return characteristics of the two assets, shown in Tables 7 to 14, and in Figures 7 to 14. Focusing first on the bond, we find that the one-period expected return on the bond increases in the level of transaction costs.10 Given the bond price effects presented above, this is what we would expect. To study the magnitude of the effects on the bond return one has to carefully distinguish between the different preference setups. For example, for the CRRA case an increase of stock transaction costs from 10 to 200 basis points yields a sizable increase in bond returns from 12.3% to 18.2%. However, for the EpsteinZin setup with IES of 1:5 the bond return only increase from 1:2% to 2:8%. That is, the use of CRRA preferences strongly overstates the effects of transaction costs on bond returns. Recall, the bond available to the two agents is a long-lived bond, i.e., it only guarantees a unit payo at time T and bond returns are therefore also volatile on a low absolute level. The effects on transaction costs on bond return volatility are presented in Table 8 and in Figure 8. The CRRA and the Epstein-Zin setups yield different results. While the results under CRRA preferences indicate an increase of bond return volatility in the presence of transaction costs, we observe a decrease in volatility for Epstein-Zin preferences. However, the effects are relatively small. Focusing on the stock, recall that the agents will often not trade the stock; therefore, they will not agree on the price of the stock and instead will have their private valuations. In Tables 9 and 10, and in Figures 9 and 10 we therefore present
23

10 - As described in Section 4.1.1, the two agents trade the bond for all combinations of transaction costs on all nodes in the tree such that the two agents always agree on bond prices and accordingly on bond returns.

Appendix
the equity premium from the views of the two agents separately. While we observe a clear pattern from the view of the first agent, i.e. an increase in the equity premium in the presence of transaction costs, the relation between transaction costs and the equity premium for the second agent is less clear. Specifically, the equity premium increases for low levels of transaction costs but decreases for higher level of transaction costs. Overall, the equity premium from the perspective of the second agent is always smaller or equal than the equity premium as perceived by the first agent. This can be explained by the fact that the second, more risk-averse agent who is more unwilling to hold the risky asset, will have a lower private valuation than the first, less risk-averse, agent. Similarly, the two agents also have a different stock return volatilities in mind. Specifically, the effect of transaction costs on the stock return volatility is inversely for the two agents. For one agent the volatility is an increasing function of transaction costs whereas the second one perceives volatility as a decreasing function of transaction costs. Which agent has the lower or higher volatility perception depends on the preference setup. Moreover, similar to the effect on bond returns, the impact of transaction costs on stock volatility are stronger in the CRRA setup. In Tables 13 and 14, and in Figures 13 and 14 we also present the Sharpe Ratio, i.e., the ratio of the equity premium and the stock return volatility. While the Sharpe Ratio is an increasing function of transaction costs for the first agent, the Sharpe Ratio of the second agent increases slightly for low levels of transaction costs and the starts to decrease. Specifically, for the EZ setup with IES of 1.5, the first
24

agent's Sharpe Ratio increases from 0.414 to 0.470 while the second agent's Sharpe Ratio decreases from 0:414 to 0:388 if we increase stock transaction costs from 10 to 200 basis points.

4.2 Two Risky Assets We now study the effect of transaction costs in a setup with two risky assets. Specifically, we want to understand how the transaction costs of one stock affect the holdings, prices and returns of the other stock.
4.2.1 Portfolio Holdings and Trading Behavior Focusing first on the portfolio holdings of the first, less risk-averse, agent, presented in Tables 15 to 17, we observe that the investment into each stock decreases strongly with the transaction costs on the stock. For example, if we increase the transaction costs on the first stock from 75 basis points to 200, while keeping the transaction costs of the second stock fixed at 100 basis points, the investment into the first stock decreases from 0.68 to 0.59, and similarly for the second stock. In contrast to this, the investment into one stock are relatively insensitive to changes of the other stock's transaction costs. For instance, if we fix the transaction costs on the first stock at 100 basis points and vary the second stock's transaction costs between 50 and 150 basis points, the holdings in the rst stock increase by about 0.002. The results for the bond investment are unambiguous: The bond holdings of the first agent increases with the transaction costs on both stocks. The explanation for this is that higher transaction costs in one of the stocks decreases the agent's holdings in this specific stock strongly, while the holdings in the other stock are virtually unaffected, such that the first

Appendix
agent has to borrow less capital to finance the stock purchases. The corresponding trading behavior of the agents are shown in Tables 18 to 20. Due to the zero transaction costs on the bond, the agents always trade the bond, whereas the stocks are traded infrequently. Within the stock universe, the agents try to smooth their consumption using the stock with the lower level of transaction costs. 4.2.2 Asset Prices The bond price in our economy is, as shown in Table 21, decreasing in both stocks' transaction costs. The lower demand for the bond in the presence of transaction costs on the stocks, as described in the preceding section, causes this price effect. Similarly, the prices of the two stocks,11 presented in Tables 22 and 23, decrease in the transaction costs of both stocks. Similar to the results in the preceding section, the effects of the transaction costs of one stock on the price of the other stock are much very small compared to the effect on the specific stock where we change the transaction costs. For instance, when varying the second stock's transaction costs between 50 and 150 basis points, the first stock price decreases by only 0:02. 4.2.3 Return Characteristics Obviously, the fact that the bond price is a decreasing function of the stocks' transaction costs, makes the bond return (shown in Table 24) an increasing function of the stocks' transaction costs. For the third preference setup the increase in bond return is about 0.9% when going from stock transaction costs of 10 basis points for each to stock transaction costs of 200 and 150 basis points for the first and the second stock, respectively. As transaction costs in the stock increase and bond returns increase, the volatility of the bond returns decrease, making the risk-return trade-o on the bond more favorable. While the volatility is low in absolute terms, it almost halves when going from the smallest to the highest transaction costs setup (see Table 25). Coming to the equity premium, the stock return volatilities and the Sharpe ratios of the two stocks as presented in Tables 26 to 37, recall that with higher transaction costs the agents will trade less such that they will have different numerical values for these quantities in mind, due to their private valuation of the risky assets. Moreover, the second agent will typically have a lower private valuation of the stocks and accordingly lower expected returns and Sharpe ratios. Accordingly, for both stocks the equity premium is an increasing function of transaction costs for the first agent and a decreasing function for the second agent. Again, a change in one stock's transaction costs only have small effects on the other stock's expected return. Based on 'midquotes', i.e., the mean value of the agents' private valuations the expected returns for both stocks increase by about 0.4-0.5% if we go from the small transaction costs setup (10/10 basis points) to the highest transaction costs setup (200/150 basis points). Similarly to the on stock results the volatilities of the two stocks are only marginally affected, such that the changes in the Sharpe ratio are mainly drive the effects on the equity premium. Accordingly, the first agents Sharpe ratios are an increasing function of transaction costs whereas the second agents' Sharpe ratios are a decreasing function. Based on mid-quotes we see a small increase in Sharpe ratios in the presence of stock transaction costs.
25

11 - As the agents trade both stocks at the initial node, they agree on the prices of both assets such that we only show the price from the view of agent 1.

Appendix
5. Conclusion
In this paper, we develop a method that allows us to obtain asset prices in a general equilibrium economy with multiple agents who are heterogeneous when there are proportional costs for trading financial assets. The agents in our model have Epstein-Zin-Weil utility functions and can be heterogeneous with respect to endowments, beliefs, and all three characteristics of their utility functions time preference, risk aversion, and elasticity of intertemporal substitution. The securities traded in the financial market include a long maturity discount bond and multiple risky stocks. Our method allows us to identify the equilibrium in a recursive fashion even in the presence of transactions costs, which make markets incomplete. This is in contrast to the usual approach for identifying the equilibrium in a general equilibrium model with incomplete financial markets, where one needs to iterate backwards and forwards until the system converges. We use our model to study the effect of transactions costs on the interest rate, prices of stocks, the expected return and risk premium on stocks, and the volatility of stock and bond returns. When there is only a single risky asset, we find that transactions costs on the stock or the bond lead investors to reduce the magnitude of their positions in the two financial assets. Transactions costs also reduce the frequency of trading equity. However, the effect on the frequency of trading the bond is much smaller; for even large transactions costs in the bond market, the investors continue to trade the bond. Moreover, because transactions costs make it less attractive to hold financial assets, there is a reduction in the prices of assets. The expected return on the bond increases with transactions costs. The effect on the volatility of bond returns, however, depends on preferences; as we increase transactions costs on the stock, the volatility of bond returns increases for the case of power utility but decreases for the case of Epstein-Zin preferences. We find that for moderate levels of transactions costs, the equity risk premium and Sharpe ratio increase with transactions costs for both investors. When there are two stocks, we find that the holding of each stock is very sensitive to its own transactions cost, but relative insensitive to the transaction cost for the other stock. As intuition would suggest, when there are two stocks, agents use the stock with the lower transactions cost to share risk and smooth consumption over time. Asset prices respond to the changes in demands described above. Hence, an increase in the transaction cost of a particular stock leads to a decrease in the price of that stock and the bond, but has only a small effect on the price of the other stock.

26

Appendix
A. The Proofs for Dynamic Programming
A.1 The Derivations of the First-Order Conditions Note, for ease of exposition we omit the subscript k for agent k and concentrate on the case for one asset with transaction costs. The case with several assets subject to transaction costs follows accordingly. Below we show that the first-order conditions derived from the recursive utility function and from the indirect utility function in the dynamic programming formulation are the same.
A.1.1 Global Solution We have to solve at each time t simultaneously the following problem:

(A1) subject to for all points in time t: (A2) Form the Lagrangian with t as the multiplier for the budget constraint:

(A3) and take the first-order conditions:

(A4)

27

Appendix
Now use that:

and plug into (A4), we get:

A.1.2 Dynamic Programming Solution Define the value function recursively as:

and write the problem as follows

(A5) subject to (A2). The Lagrangian:

with first-order conditions

(A6)

28

(A7)

Appendix

(A8) The envelope theorem gives us:

which we can plug into (A8) to get:

(A9) The first-order conditions for the global case and the recursive case are the same, except that in the global formulation the utility function Vt shows up, and in the recursive formulation the value function Jt shows up. However, in optimum, when we solve the global case for all t, the utility function and the value function are the same.

29

Appendix
Tables
Table 1: One Stock Case: Bond Investment Agent 1 This tables provides selected results from the general equilibrium problem with transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one long-term riskless (Bond) assets. Trading in each of the assets may incur transaction costs.

Table 2: One Stock Case: Stock Investment Agent 1

30

Appendix
Table 3: One Stock Case: Number of Bond Trades This tables provides selected results from the general equilibrium problem with transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one long-term riskless (Bond) assets. Trading in each of the assets may incur transaction costs.

Table 4: One Stock Case: Number of Stock Trades

31

Appendix
Table 5: One Stock Case: Bond Price This tables provides selected results from the general equilibrium problem with transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock)and one long-term riskless (Bond) assets. Trading in each of the assets may incur transaction costs.

Table 6: One Stock Case: Stock Price

32

Appendix
Table 7: One Stock Case: Expected Interest Rate This tables provides selected results from the general equilibrium problem with transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one long-term riskless (Bond) assets. Trading in each of the assets may incur transaction costs.

Table 8: One Stock Case: Volatility of Bond Return

33

Appendix
Table 9: One Stock Case: Equity Premium Agent 1 This tables provides selected results from the general equilibrium problem with transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one long-term riskless (Bond) assets. Trading in each of the assets may incur transaction costs.

Table 10: One Stock Case: Equity Premium Agent 2

34

Appendix
Table 11: One Stock Case: Volatility of Stock Return Agent 1 This tables provides selected results from the general equilibrium problem with transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one long-term riskless (Bond) assets. Trading in each of the assets may incur transaction costs.

Table 12: One Stock Case: Volatility of Stock Return Agent 2

35

Appendix
Table 13: One Stock Case: Sharpe Ratio Agent 1 This tables provides selected results from the general equilibrium problem with transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one long-term riskless (Bond) assets. Trading in each of the assets may incur transaction costs.

Table 14: One Stock Case: Sharpe Ratio Agent 2

36

Appendix
Table 15: Two Stocks Case: Bond Investment Agent 1 This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

Table 16: Two Stocks Case: Stock 1 Investment Agent 1 This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

37

Appendix
Table 17: Two Stocks Case: Stock 2 Investment Agent 1 This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

Table 18: Two Stocks Case: Number of Bond Trades This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

38

Appendix
Table 19: Two Stocks Case: Number of Stock 1 Trades This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

Table 20: Two Stocks Case: Number of Stock 2 Trades This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

39

Appendix
Table 21: Two Stocks Case: Bond Price This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coecients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocksmay incur transaction costs.

Table 22: Two Stocks Case: Stock 1 Price This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

40

Appendix
Table 23: Two Stocks Case: Stock 2 Price This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

Table 24: Two Stocks Case: Expected Interest Rate This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

41

Appendix
Table 25: Two Stocks Case: Volatility of Bond Return This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

Table 26: Two Stocks Case: Equity Premium Stock 1 Agent 1 This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

42

Appendix
Table 27: Two Stocks Case: Equity Premium Stock 1 Agent 2 This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

Table 28: Two Stocks Case: Equity Premium Stock 2 Agent 1 This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

43

Appendix
Table 29: Two Stocks Case: Equity Premium Stock 2 Agent 2 This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

Table 30: Two Stocks Case: Volatility of Stock 1 Return Agent 1 This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

44

Appendix
Table 31: Two Stocks Case: Volatility of Stock 1 Return Agent 2 This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

Table 32: Two Stocks Case: Volatility of Stock 2 Return Agent 1 This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

45

Appendix
Table 33: Two Stocks Case: Volatility of Stock 2 Return Agent 2 This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

Table 34: Two Stocks Case: Sharpe Ratio Stock 1 Agent 1 This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2= 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

46

Appendix
Table 35: Two Stocks Case: Sharpe Ratio Stock 1 Agent 2 This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

Table 36: Two Stocks Case: Sharpe Ratio Stock 2 Agent 1 This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

47

Appendix
Table 37: Two Stocks Case: Sharpe Ratio Stock 2 Agent 2 This tables provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have two risky (Stock 1 and Stock 2) and one long-term riskless (Bond) assets. Trading in risky stocks may incur transaction costs.

48

Appendix
Figures
Figure 1: One Stock Case: Bond Investment Agent 1 This figure provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one long-term riskless (Bond) assets. Trading in each of the assets may incur transaction costs. The solid lines refer to the case where there are no transaction costs for the bond trading, and the dashed line to the case where bond trading incurs 10 bp costs per value traded.

49

Appendix
Figure 2: One Stock Case: Stock Investment Agent 1 This figure provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one long-term riskless (Bond) assets. Trading in each of the assets may incur transaction costs. The solid lines refer to the case where there are no transaction costs for the bond trading, and the dashed line to the case where bond trading incurs 10 bp costs per value traded.

50

Appendix
Figure 3: One Stock Case: Number of Bond Trades This figure provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one longterm riskless (Bond) assets. Trading in each of the assets may incur transaction costs. The solid lines refer to the case where there are no transaction costs for the bond trading, and the dashed line to the case where bond trading incurs 10 bp costs per value traded.

51

Appendix
Figure 4: One Stock Case: Number of Stock Trades This figure provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one longterm riskless (Bond) assets. Trading in each of the assets may incur transaction costs. The solid lines refer to the case where there are no transaction costs for the bond trading, and the dashed line to the case where bond trading incurs 10 bp costs per value traded.

52

Appendix
Figure 5: One Stock Case: Bond Price This figure provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one longterm riskless (Bond) assets. Trading in each of the assets may incur transaction costs. The solid lines refer to the case where there are no transaction costs for the bond trading, and the dashed line to the case where bond trading incurs 10 bp costs per value traded.

53

Appendix
Figure 6: One Stock Case: Stock Price This figure provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one longterm riskless (Bond) assets. Trading in each of the assets may incur transaction costs. The solid lines refer to the case where there are no transaction costs for the bond trading, and the dashed line to the case where bond trading incurs 10 bp costs per value traded.

54

Appendix
Figure 7: One Stock Case: Expected Interest Rate This figure provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one longterm riskless (Bond) assets. Trading in each of the assets may incur transaction costs. The solid lines refer to the case where there are no transaction costs for the bond trading, and the dashed line to the case where bond trading incurs 10 bp costs per value traded.

55

Appendix
Figure 8: One Stock Case: Volatility of Bond Return This figure provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one longterm riskless (Bond) assets. Trading in each of the assets may incur transaction costs. The solid lines refer to the case where there are no transaction costs for the bond trading, and the dashed line to the case where bond trading incurs 10 bp costs per value traded.

56

Appendix
Figure 9: One Stock Case: Equity Premium Agent 1 This figure provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one longterm riskless (Bond) assets. Trading in each of the assets may incur transaction costs. The solid lines refer to the case where there are no transaction costs for the bond trading, and the dashed line to the case where bond trading incurs 10 bp costs per value traded.

57

Appendix
Figure 10: One Stock Case: Equity Premium Agent 2 This figure provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one longterm riskless (Bond) assets. Trading in each of the assets may incur transaction costs. The solid lines refer to the case where there are no transaction costs for the bond trading, and the dashed line to the case where bond trading incurs 10 bp costs per value traded.

58

Appendix
Figure 11: One Stock Case: Volatility of Stock Return Agent 1 This figure provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one longterm riskless (Bond) assets. Trading in each of the assets may incur transaction costs. The solid lines refer to the case where there are no transaction costs for the bond trading, and the dashed line to the case where bond trading incurs 10 bp costs per value traded.

59

Appendix
Figure 12: One Stock Case: Volatility of Stock Return Agent 2 This figure provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one longterm riskless (Bond) assets. Trading in each of the assets may incur transaction costs. The solid lines refer to the case where there are no transaction costs for the bond trading, and the dashed line to the case where bond trading incurs 10 bp costs per value traded.

60

Appendix
Figure 13: One Stock Case: Sharpe Ratio Agent 1 This figure provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one longterm riskless (Bond) assets. Trading in each of the assets may incur transaction costs. The solid lines refer to the case where there are no transaction costs for the bond trading, and the dashed line to the case where bond trading incurs 10 bp costs per value traded.

61

Appendix
Figure 14: One Stock Case: Sharpe Ratio Agent 2 This figure provides the selected results from solving the general equilibrium problem with the transaction costs proportional to the value of the financial asset traded. The economy has two heterogeneous agents maximizing their lifetime utility of consumption over 5 time periods. We have three setups in terms of agents' preferences: (i) setup 1 with two CRRA agents having the relative risk aversion (RRA) coefficients 1 = 2 and 2 = 5, (ii) setup 2 with EZ agents, having the same RRA 1 = 2 and 2 = 5, and elasticity of intertemporal substitution (EIS) = 0.5, (iii) setup 3 with EZ agents, having the same RRA 1 = 2 and 2 = 5 and EIS = 1.5. In all setups we have one risky (Stock) and one longterm riskless (Bond) assets. Trading in each of the assets may incur transaction costs. The solid lines refer to the case where there are no transaction costs for the bond trading, and the dashed line to the case where bond trading incurs 10 bp costs per value traded.

62

References
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EDHEC-Risk Institute Position Papers and Publications (2008-2011)

2011 Publications
Campani, C.H. and F. Goltz. A Review of corporate bond indices: Construction principles, return heterogeneity, and fluctuations in risk exposures (June). Martellini, L., and V. Milhau. Capital structure choices, pension fund allocation decisions, and the rational pricing of liability streams (June). Amenc, N., F. Goltz, and S. Stoyanov. A post-crisis perspective on diversification for risk management (May). Amenc, N., F. Goltz, Martellini, L., and L. Tang. Improved beta? A comparison of indexweighting schemes (April). Amenc, N., F. Goltz, Martellini, L., and D. Sahoo. Is there a risk/return tradeoff across stocks? An answer from a long-horizon perspective (April). Sender, S. The elephant in the room: Accounting and sponsor risks in corporate pension plans (March). Martellini, L., and V. Milhau. Optimal design of corporate market debt programmes in the presence of interest-rate and inflation risks (February).

2010 Publications
Amenc, N., and S. Sender. The European fund management industry needs a better grasp of non-financial risks (December). Amenc, N., S, Focardi, F. Goltz, D. Schrder, and L. Tang. EDHEC-Risk European private wealth management survey (November). Amenc, N., F. Goltz, and L. Tang. Adoption of green investing by institutional investors: A European survey (November). Martellini, L., and V. Milhau. An integrated approach to asset-liability management: Capital structure choices, pension fund allocation decisions and the rational pricing of liability streams (November). Hitaj, A., L. Martellini, and G. Zambruno. Optimal Hedge Fund Allocation with Improved Estimates for Coskewness and Cokurtosis Parameters (October). Amenc, N., F. Goltz, Martellini, L., and V. Milhau. New frontiers in benchmarking and liability-driven investing (September). Martellini, L., and V. Milhau. From deterministic to stochastic life-cycle investing: Implications for the design of improved forms of target date funds (September). Martellini, L., and V. Milhau. Capital structure choices, pension fund allocation decisions and the rational pricing of liability streams (July). Sender, S. EDHEC survey of the asset and liability management practices of European pension funds (June). Goltz, F., A. Grigoriu, and L. Tang. The EDHEC European ETF survey 2010 (May). Martellini, L., and V. Milhau. Asset-liability management decisions for sovereign wealth funds (May).

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EDHEC-Risk Institute Position Papers and Publications (2008-2011)

Amenc, N., and S. Sender. Are hedge-fund UCITS the cure-all? (March). Amenc, N., F. Goltz, and A. Grigoriu. Risk control through dynamic core-satellite portfolios of ETFs: Applications to absolute return funds and tactical asset allocation (January). Amenc, N., F. Goltz, and P. Retkowsky. Efficient indexation: An alternative to cap-weighted indices (January). Goltz, F., and V. Le Sourd. Does finance theory make the case for capitalisation-weighted indexing? (January).

2010 Position Papers

Amenc, N., and V. Le Sourd. The performance of socially responsible investment and sustainable development in France: An update after the financial crisis (September). Amenc, N., A. Chron, S. Gregoir, and L. Martellini. Il faut prserver le Fonds de Rserve pour les Retraites (July). Amenc, N., P. Schoefler, and P. Lasserre. Organisation optimale de la liquidit des fonds dinvestissement (March). Lioui, A. Spillover effects of counter-cyclical market regulation: Evidence from the 2008 ban on short sales (March).

2009 Publications
Sender, S. Reactions to an EDHEC study on the impact of regulatory constraints on the ALM of pension funds (October). Amenc, N., L. Martellini, V. Milhau, and V. Ziemann. Asset-liability management in private wealth management (September). Amenc, N., F. Goltz, A. Grigoriu, and D. Schroeder. The EDHEC European ETF survey (May). Sender, S. The European pension fund industry again beset by deficits (May). Martellini, L., and V. Milhau. Measuring the benefits of dynamic asset allocation strategies in the presence of liability constraints (March). Le Sourd, V. Hedge fund performance in 2008 (February). La gestion indicielle dans l'immobilier et l'indice EDHEC IEIF Immobilier d'Entreprise France (February). Real estate indexing and the EDHEC IEIF Commercial Property (France) Index (February). Amenc, N., L. Martellini, and S. Sender. Impact of regulations on the ALM of European pension funds (January). Goltz, F. A long road ahead for portfolio construction: Practitioners' views of an EDHEC survey. (January).

2009 Position Papers

Till, H. Has there been excessive speculation in the US oil futures markets? (November). Amenc, N., and S. Sender. A welcome European Commission consultation on the UCITS depositary function, a hastily considered proposal (September).

66

EDHEC-Risk Institute Position Papers and Publications (2008-2011)

Sender, S. IAS 19: Penalising changes ahead (September). Amenc, N. Quelques rflexions sur la rgulation de la gestion d'actifs (June). Giraud, J.-R. MiFID: One year on (May). Lioui, A. The undesirable effects of banning short sales (April). Gregoriou, G., and F.-S. Lhabitant. Madoff: A riot of red flags (January).

2008 Publications
Amenc, N., L. Martellini, and V. Ziemann. Alternative investments for institutional investors: Risk budgeting techniques in asset management and asset-liability management (December). Goltz, F., and D. Schroeder. Hedge fund reporting survey (November). DHondt, C., and J.-R. Giraud. Transaction cost analysis A-Z: A step towards best execution in the post-MiFID landscape (November). Amenc, N., and D. Schroeder. The pros and cons of passive hedge fund replication (October). Amenc, N., F. Goltz, and D. Schroeder. Reactions to an EDHEC study on asset-liability management decisions in wealth management (September). Amenc, N., F. Goltz, A. Grigoriu, V. Le Sourd, and L. Martellini. The EDHEC European ETF survey 2008 (June). Amenc, N., F. Goltz, and V. Le Sourd. Fundamental differences? Comparing alternative index weighting mechanisms (April). Le Sourd, V. Hedge fund performance in 2007 (February). Amenc, N., F. Goltz, V. Le Sourd, and L. Martellini. The EDHEC European investment practices survey 2008 (January).

2008 Position Papers

Amenc, N., and S. Sender. Assessing the European banking sector bailout plans (December). Amenc, N., and S. Sender. Les mesures de recapitalisation et de soutien la liquidit du secteur bancaire europen (December). Amenc, N., F. Ducoulombier, and P. Foulquier. Reactions to an EDHEC study on the fair value controversy (December). With the EDHEC Financial Analysis and Accounting Research Centre. Amenc, N., F. Ducoulombier, and P. Foulquier. Ractions aprs ltude. Juste valeur ou non : un dbat mal pos (December). With the EDHEC Financial Analysis and Accounting Research Centre. Amenc, N., and V. Le Sourd. Les performances de linvestissement socialement responsable en France (December). Amenc, N., and V. Le Sourd. Socially responsible investment performance in France (December).
67

EDHEC-Risk Institute Position Papers and Publications (2008-2011)

Amenc, N., B. Maffei, and H. Till. Les causes structurelles du troisime choc ptrolier (November). Amenc, N., B. Maffei, and H. Till. Oil prices: The true role of speculation (November). Sender, S. Banking: Why does regulation alone not suffice? Why must governments intervene? (November). Till, H. The oil markets: Let the data speak for itself (October). Amenc, N., F. Goltz, and V. Le Sourd. A comparison of fundamentally weighted indices: Overview and performance analysis (March). Sender, S. QIS4: Significant improvements, but the main risk for life insurance is not taken into account in the standard formula (February). With the EDHEC Financial Analysis and Accounting Research Centre.

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EDHEC-Risk Institute is part of EDHEC Business School, one of Europes leading business schools and a member of the select group of academic institutions worldwide to have earned the triple crown of international accreditations (AACSB, EQUIS, Association of MBAs). Established in 2001, EDHEC-Risk Institute has become the premier European centre for applied financial research. In partnership with large financial institutions, its team of 66 permanent professors, engineers and support staff implements six research programmes and ten research chairs focusing on asset allocation and risk management in the traditional and alternative investment universes. The results of the research programmes and chairs are disseminated through the three EDHEC-Risk Institute locations in London, Nice, and Singapore.

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