ASSET PRICING IN ECONOMIES WITH FRICTIONS

This paper examines how proportional transaction costs, short-sale con straints, and margin requirements affect inferences based on asset ret urn data about intertemporal marginal rates of substitution (IMRSs). I t is shown that small transaction costs can greatly reduce the require d variability of IMRSs. This suggests that the low variability of many parametric, aggregate consumption based IMRSs need not be inconsisten t with asset return data. Euler inequalities for a transaction cost ec onomy with power utility are tested using aggregate consumption data a nd returns on stocks and short maturity U.S. Treasury bills. In the ma jority of cases there is little evidence against power utility specifi cations with low risk-aversion parameters. The results are obtained wi th transaction costs on stocks as small as .5% of price, and are in sh arp contrast to the strong rejection of the analogous Euler equalities for a frictionless economy.