Transactions costs and the equity premium puzzle

Campbell and Cochrane (1999b) habit formation model is able to resolve the equity premium and riskless interest rate puzzles, but only for high values of relative risk aversion. In this paper, I incorporate transactions costs in the Campbell and Cochrane (1999b) model and find that the required level of relative risk aversion at the steady state reduces from 35 to 15. Thus, transactions costs seem able to reduce, but not completely solve, the remaining puzzle.

Automated summary

This paper investigates the impact of incorporating transactions costs into the Campbell and Cochrane (1999b) model. The findings suggest that transactions costs can reduce the required level of relative risk aversion, but cannot completely solve the puzzle.