Is Market Volatility Systematically Priced While Illiquidity Is Only Priced on the Down-Side?

I show in a setting of a buyer and seller with the same preferences trading two related assets so as to share volatility risk that illiquidity and virtually all impediments to trade cannot be priced in the absence of excess short-selling costs. This is because the buyer values the asset at the low Bid-price and seller at the high Ask-price. When market clears, the buyer and seller order-flows cancel out leaving the midpoint price independent of the “tax wedge”. Using this admittedly “stylized” model and very modest CARA and CRRA risk preferences, I generate Mehra and Prescott's (1985) equity premium of about 8% and negligible yield on T-bills, together with the observed turnovers of both T-Bills and equity securities, to show that market volatility is systematically priced. Moreover, only in the presence of non-binding but higher short-selling costs that steepen the supply response to adverse demand shocks, can illiquidity be priced and a number of other anomalies explained. I reconcile my findings with Amihud and Mendelson's (1986) treatment of the buyer by adding in the seller's perspective which provides the necessary theoretical underpinnings to explain the asymmetric empirical findings of Brennan, Chordia, Subrahmanyam, and Tong (2012), Brennan, Huh, and Subrahmanyam (2013, 2015) and several others