TY - JOUR AU - Grossman,Sanford J. AU - Laroque,Guy TI - Asset Pricing and Optimal Portfolio Choice in the Presence of Illiquid Durable Consumption Goods JF - National Bureau of Economic Research Working Paper Series VL - No. 2369 PY - 1988 Y2 - June 1988 UR - http://www.nber.org/papers/w2369 L1 - http://www.nber.org/papers/w2369.pdf N1 - Author contact info: Sanford J. Grossman QFS Asset Management, L.P. 10 Glenville Street Greenwich, CT 06831 Tel: 203/983-5600 Fax: 203/532-8250 E-Mail: sgrossman@qfsfunds.com guy laroque University College London Department of Economics Gower Street London, ENGLAND E-Mail: laroque@ensae.fr AB - We analyze a model of optimal consumption and portfolio selection in which consumption services are generated by holding a durable good. The durable good is illiquid in that a transaction cost must be paid when the good is sold. It is shown that optimal consumption is not a smooth function of wealth; it is optimal for the consumer to wait until a large change in wealth occurs before adjusting his consumption. As a consequence, the consumption based capital asset pricing model fails to hold. Nevertheless, it is shown that the standard, one factor, market portfolio based capital asset pricing model does hold in this environment. It is shown that the optimal durable level is characterized by three numbers (not random variables), say x, y, and z (where x < y < z). The consumer views the ratio of consumption to wealth (c/W) as his state variable. If this ratio is between x and z, then he does not sell the durable. If c/W is less than x or greater than z, then he sells his durable and buys a new durable of size S so that S/W = y. Thus y is his "target" level of c/W. If the stock market moves up enough so that c/W falls below x, then he sells his small durable to buy a larger durable. However, there will be many changes in the value of his wealth for which c/W stays between x and z, and thus consumption does not change. Numerical simulations show that small transactions costs can make consumption changes occur very infrequently. Further, the effect of transactions costs on the demand for risky assets is substantial. ER -