Estimating asset pricing models with frictions

•We estimate confidences sets of risk aversion and trading costs implied by asset pricing models with frictions.•Introducing short-selling costs for Treasury bills accounts for the low observed risk-free rate.•The confidence sets show upper bounds on risk aversion to be at reasonable levels.•Short-selling costs for Treasuries are not necessary under recursive preferences.

We jointly quantify the magnitude of risk aversion and transactions costs implied by asset pricing models with trading frictions. With constant relative risk aversion and symmetric transactions costs, estimated transactions costs on Treasury bills are implausibly high, a manifestation of the risk-free rate puzzle. Introducing short-selling costs for Treasury bills offers a resolution of the puzzle. The resulting confidence sets show upper bounds on risk aversion to be at reasonable levels. Short-selling costs for Treasuries are not necessary under recursive preferences.