  We study how trading costs are reflected in equilibrium returns. To this end,
we develop a tractable continuous-time risk-sharing model, where heterogeneous
mean-variance investors trade subject to a quadratic transaction cost. The
corresponding equilibrium is characterized as the unique solution of a system
of coupled but linear forward-backward stochastic differential equations.
Explicit solutions are obtained in a number of concrete settings. The
sluggishness of the frictional portfolios makes the corresponding equilibrium
returns mean-reverting. Compared to the frictionless case, expected returns are
higher if the more risk-averse agents are net sellers or if the asset supply
expands over time.
