The Cost of Stock Trading to Firms

Abstract

I study the effects of stock trading costs into a dynamic corporate finance model with financing frictions. When trading entails a cost, the issuing firm needs to pay an illiquidity premium to shareholders, which increases the firm's cost of capital and the opportunity cost of cash. The illiquidity premium leads to a decrease in the firm's target cash, exacerbates financial constraints, increases default risk, and reduces firm value. This firm's response can feed back into trading costs and amplify their real effects. The model warns of some consequences of regulatory restrictions on trading in financial markets.

Keywords: Cash reserves, Transaction costs, Real effects of financial markets

JEL Classification: G32; G35