liquidity premium of class L stocks must be xcL cL/hr L. Therefore,   r r 1 c L hr L L   (9.12) There are two lessons to be learned from this analysis. First, as predicted, equilibrium expected rates of return are bid up to compensate for transaction costs, as demonstrated by equations 9.11 and 9.12. Second, the illiquidity premium is not a linear function of trans- action costs. In fact, the incremental illiquidity premium steadily declines as transaction costs increase. To see that this is so, suppose that cL is 1% and cI cL is also 1%. There- fore, the transaction cost increases by 1% as you move out of bills into the more liquid stock class, and by another 1% as you move into the illiquid stock class. Equation 9.12 shows that the illiquidity premium of class L stocks over no-transaction-cost bills is then 1/hr L, and equation 9.11 shows that the illiquidity premium of class I over class L stocks is 1/hLI. But hLI exceeds hrL (see Figure 9.8), so we conclude that the incremental effect of illiquidity declines as we move into ever more illiquid assets. The reason for this last result is simple. Recall that investors will self-select into differ- ent asset classes, with longer-term investors holding assets with the highest gross return but that are the most illiquid. For these investors, the effect of illiquidity is less costly because trading costs can be amortized over a longer horizon. Therefore, as these costs increase, the investment horizon associated with the holders of these assets also increases, which miti- gates the impact on the required gross rate of return. III. Equilibrium In Capital Markets 9. The Capital Asset Pricing Model The McGraw−Hill Companies, 2001           284 PART III Equilibrium in Capital Markets           CONCEPT C H E C K ☞ QUESTION 7 Consider a very illiquid asset class of stocks, class V, with cV > cI. Use a graph like Figure 9.9 to convince yourself that there is an investment horizon, hIV, for which an investor