Stock Splits and the Trading Speed Improvement Hypothesis

Abstract

Managers have repeatedly indicated in surveys that stock splits are intended to improve liquidity. However, previous studies using bid-ask spread and turnover as measures of liquidity find results to the contrary. This paper offers a new perspective on the issue. Stock splits can make buying shares more affordable to smaller investors, and split-induced higher trading costs can help attract more brokers to promote the stock and new limit-order traders to supply liquidity. Accordingly, we hypothesize that managers of firms facing order execution difficulty and lock-in risk have incentives to use stock splits to improve trading speed at the expense of higher trading costs. Consistent with the hypothesis, we find evidence that firms face trading difficulty prior to splits, and following the split trading speed improves. On average, about 72 percent of the split announcement returns could be attributed to the net benefit of anticipated trading speed improvement. Our findings indicate that trading difficulty is an important factor in firms' split decisions, and that the benefit of the improved trading speed outweighs the increased trading costs.

Keywords: Stock Splits, Liquidity, Trading Speed, Trading Costs

JEL Classification: G10, G30