The Determinants of Equity Illiquidity

One under-examined cost of trading is illiquidity. This paper measures equity illiquidity as the change in a firm's stock price associated with its observed trading volume. Increasing the magnitude of net turnover during a 5-minute interval by 0.1% of the shares outstanding produces an average incremental price effect of 2.71%.This average, however, masks considerable cross-sectional variation. To explain this variation, we consider a set of predetermined variables that serve as proxies for (a) the severity of adverse selection in the equity market, (b) the level of the non-adverse selection costs of making a market in the stock, and (c) the extent of shareholder heterogeneity. Consistent with these theories, we present evidence that illiquidity varies cross-sectionally as a function of these predetermined variables.We examine the change in liquidity surrounding stock splits. It is commonly argued that stock splits are done precisely to enhance the liquidity of a stock, though the existing empirical support for this claim is mixed. We find that our measure of illiquidity increases by a statistically significant amount following a split, evidence that liquidity has been compromised, rather than improved, by the split