The Real Effects of Financing and Trading Frictions

Abstract

I develop a model that studies the interplay between investors' trading frictions and firms' financial constraints and the ensuing effects on corporate policies. The model shows that bid-ask spreads increase not only the cost of external financing but also the cost of internal funds, leading to smaller cash reserves and larger payouts. As a result, firm's financial constraints tighten, liquidation risk increases, investment decreases, and firm value declines. These outcomes are reinforced when internalized by liquidity providers, giving rise to a feedback that makes the bid-ask spread wider and amplifies its detrimental effects on firm financial constraints and value.

Keywords: Financial constraints, transaction costs, real effects of financial markets, small firms

JEL Classification: G32, G35, G31, G28