Early finance studies have naturally abstracted from all market imperfections, information asymmetries, and trading frictions, such as liquidity. However, it is now becoming clear that an asset's liquidity---the ease at which it can be traded---is an important determinant of its return distribution. This dissertation comprises two separate essays on the effects of liquidity on portfolio choices and asset prices.; The first essay is an empirical study on the time series effect of changes in liquidity on optimal portfolio allocations. Liquidity is measured by turnover, dollar volume, or price impact. Using a sample of NYSE stocks from 1963--2000, we document a very interesting temporal dimension to the effects of changes in liquidity: whereas optimal weights are strongly increasing functions of liquidity at the very short daily and weekly horizons, they become decreasing functions of liquidity at longer monthly horizons. Overall, the dependence of optimal weights on liquidity is most noticeable for small stocks at short investment horizons. Finally, we observe that the optimal conditional portfolio weights are never negative, which may help explain the low level of short selling observed in the US stock market.; The second essay examines the liquidity premium in a theoretical dynamic portfolio-choice model. The liquidity premium is defined as the additional return necessary to compensate the investor for the adverse price impact of trading. We analyze how the liquidity premium and the optimal trading strategies depend upon the characteristics of investors and price impact. Our analysis offers an intuitive theoretical explanation for the "puzzling" empirical finding that the liquidity premium decreases with the volatility of liquidity. Further, we find that uncertainty about the investment horizon substantially increases the liquidity premium, challenging the conventional wisdom that liquidity is not as important for long-term investors.
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