Abstract

This thesis analyzes an investor’s portfolio choice and liquidity premium in the presence of an illiquid stock. Illiquidity is modelled by means of convex transaction costs which an investor has to pay for trading a stock. An investor is assumed to trade in the presence of a stochastic endowment which is used to generate long-term trading demands. I find that the endowment generates long-term trading incentives only if there exist correlations between the endowment and stocks returns. These incentives result in the liquidity premium which makes only a fraction of a percent of the risk premium. The portfolio choice and the conditional liquidity premium can be determined in a closed form in the case of the absence of these correlations and the main economic intuition behind the findings is confirmed.