An Equilibrium Model of Imperfect Hedging with Transaction Costs

The impact of transaction costs on asset pricing in equilibrium is rarely studied. We study an equilibrium model with proportional transaction costs where two investors trade in a derivative to hedge non-traded endowments. For any positive transaction cost there always exist no trade equilibria. There are also equilibria with trade. High equilibrium risk exposure leads to smaller costs of setting up and unwinding initial and terminal hedge positions. When the investors have similar risk aversions, the equilibrium liquidity premia and risk exposure are high. The equilibrium expected rebalancing costs are bell-shaped with respect to the difference in risk aversions.