Trading Frequency and Asset Pricing on the London Stock Exchange: Evidence from a New Price Impact Ratio

Abstract:     
In this study we propose a new price impact ratio as an alternative to the widely used Amihud’s (2002) Return-to-Volume ratio (RtoV). This new measure, which is deemed Return-to-Turnover ratio (RtoTR), essentially modifies RtoV by substituting trading volume in its denominator with the turnover ratio for each security. We demonstrate that the new price impact ratio has a number of appealing features. Using daily data from all stocks listed on the London Stock Exchange over the period 1991-2008, we provide overwhelming evidence that this ratio, while being unequivocal to construct and interpret, is also free of size bias. More importantly, it encapsulates the stocks' cross-sectional variability in trading frequency, a relatively neglected but important determinant of stock returns given the recently observed trends in financial markets. Overall, our findings argue against the conventional wisdom that there is a simple direct link between trading costs and stock prices by strongly suggesting that it is the compound effect of trading frequency and transaction costs that matters for asset pricing, not each aspect in isolation.

Number of Pages in PDF File: 53

Keywords: Trading Frequency, Transaction Costs, Price Impact Ratio, Asset Pricing, Illiquidity

JEL Classification: G10, G12, G14

working papers series