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Market Closure and the Liquidity Premium Puzzle

In contrast to empirical evidence, standard theories conclude that transaction costs only have a second order effect on liquidity premia. In this paper, we show that if one incorporates the well-established fact that market volatility during trading periods is significantly higher than during nontrading periods, then transaction costs have a first order effect that is much greater than that found by the existing theoretical literature and largely comparable to empirical findings. Different from the existing literature, the main source of the greater liquidity premium in our model is not higher transaction cost payment, but the substantially "suboptimal" trading strategy caused by market closure. We show that our main results hold in a similar discrete time model and in a multiple stock setting. Extensive empirical analysis strongly supports our unique prediction that stocks with greater return variance variations across trading and nontrading periods require higher liquidity premia.