1 Can “Illiquidity” Explain the Equity Premium Puzzle? The Value of Endogenous Market Trading Peter L. Swan ∗ School of Banking and Finance, Faculty of Commerce University of New South Wales Version Dated June 17, 2002 ABSTRACT Yes. I aim to establish empirically that the “equity premium” puzzle, with its 6% excess return per annum over Treasury bills for the last 100 years on the NYSE, can be explained once the value of endogenous stock market trading is incorporated into investor preferences. Within my framework, investors enjoy trading. According to my model, the “investor surplus” from trading liquid Treasury bills relative to illiquid equity is exactly compensated for by the expected equity premium. Observed transaction cost and liquidity differentials between equity and bills are consistent with the premium. Extensive tests are carried out on Australian and US NYSE data for 1955-98. The puzzle concerning the volatility of the stochastic discount factor also appears to be explained by trading behavior, which is of comparable volatility. Reasonably accurate estimates of transactions costs are extracted just from daily dividend yields and turnover. Transaction costs would need to be 400% higher to explain the premium by the “amortized spread”, together with exogenous trading and habit formation. An ability to create unlimited wealth, implicit in some existing models, no longer applies. Additionally, the model explains the further 15-20% pa discount on illiquid “letter” stock. Key words: equity premium, asset prices, liquidity, trading, transaction cost, amortized spread. JEL Classification: G120, G110, G200 ∗ School of Banking and Finance, Faculty of Commerce, University of New South Wales, Sydney NSW 2052 Australia; email: peter.swan@unsw.edu.au . I wish to thank the Australian Research Council Australian Professorial Fellowship scheme for financial support. I wish to thank Michael Aitken, Henk Berkman, Stuart Dennon, Stephen Fisher, Kingsley Fong, Gerald Garvey, Tro Kortian, Narayan Naik and Joakim Westerholm, for encouragement and assistance. SIRCA and the ASX kindly provided access to the underlying intra-day data. I also wish to thank Yakov Amihud, John Campbell, Zhian Chen, Doug Foster and other participants at an AGSM seminar, participants at the Reserve Bank of Australia and UNSW Conference seminars, and at the University of NSW, University of Western Australia, University of Sydney and City University of Hong Kong seminars, Magnus Gammelgard, Mikael Gellback, Ed Prescott, Jeff Sheen and David Simmonds for comments on an earlier draft. Responsibility for both errors and views expressed is entirely my own. George Sofianos kindly provided NYSE turnover data and assisted with the provision of TAQ data. Jeremy J. Siegal kindly provided data on bond yields.  Copyright 2000, 2001, 2002 by Peter L. Swan. All rights reserved. Short sections of text, not exceeding two paragraphs, may be quoted without explicit permission provided that full credit is given to the source.