Measuring Institutional Trading Costs and the Implications for Finance Research: The Case of Tick Size Reductions
47 Pages Posted: 17 Oct 2018 Last revised: 1 Nov 2018
Date Written: November 1, 2018
The role of institutional investors has attracted significant attention in finance research. Relying on commonly used liquidity measures, numerous studies have investigated the impact of institutional trading costs on firm activities. In this paper, we demonstrate that many widely used liquidity measures do not adequately capture institutional trading costs. Using proprietary data on institutional trade orders, we construct a price impact measure that better represents the costs faced by institutional investors. We find that price impact is not correlated with many common liquidity proxies, most of which capture the cost of executing a small order immediately. In addition, institutional trading costs are not dramatically impacted by the implementation of decimalization in U.S. equity markets, casting doubt on the widely used identification strategy that employs decimalization to exploit an exogenous improvement in stock liquidity. Indeed, we find that conclusions from prior research are significantly altered when we measure liquidity using data on institutional trades. This result is particularly salient when institutions are proposed as the mechanism initiating changes in firm behavior.
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