Trading Constraints and Illiquidity Discounts

European Journal of Finance, Volume 18, Issue 1, 2012

54 Pages Posted: 20 Dec 2008 Last revised: 22 Jun 2013

See all articles by Wenxuan Hou

Wenxuan Hou

University of Edinburgh - Business School; University of Edinburgh - Business School; Shanghai Lixin University of Accounting and Finance

Sydney Howell

University of Manchester - Manchester Business School

Date Written: December 30, 2008

Abstract

Acting as the source of exogenous illiquidity, trading constraints prevent free trading of shares and discount their value relative to freely-traded counterparts with identical dividends and voting rights. This paper numerically solves the theoretical illiquidity discounts for the restricted shares with long constraint horizon and then reconciles the contradictions in the results of various theoretical models. With control of leveraged positions, illiquidity discounts increase with the volatility, and their size is greatly diminished. We also empirically test the theories within the unique setting of China, which has the largest population of restricted shares worldwide. Large discounts are documented in two forms of occasional transactions in restricted shares: namely auctions and transfers. The results empirically verify the theoretical findings by showing that illiquidity discounts in auctions increase with both the volatility and constraint horizons. The results from transfers, however, are not always significant as the transfers are made privately and may be subject to price manipulation when the involved parties are related.

Keywords: Exogenous Illiquidity, Restricted Share, Trading Constraint, Constraint Horizon, Illiquidity Discount, China

JEL Classification: G11, G12, G30

Suggested Citation

Hou, Wenxuan and Hou, Wenxuan and Howell, Sydney, Trading Constraints and Illiquidity Discounts (December 30, 2008). European Journal of Finance, Volume 18, Issue 1, 2012, Available at SSRN: https://ssrn.com/abstract=984764 or http://dx.doi.org/10.2139/ssrn.984764

Wenxuan Hou (Contact Author)

University of Edinburgh - Business School ( email )

University of Edinburgh
29 Buccleuch Place
Edinburgh, Scotland EH8 9JS
United Kingdom

HOME PAGE: http://www.wenxuanhou.com

University of Edinburgh - Business School ( email )

University of Edinburgh
29 Buccleuch Place
Edinburgh, Scotland EH8 9JS
United Kingdom

HOME PAGE: http://www.wenxuanhou.com

Shanghai Lixin University of Accounting and Finance ( email )

Sydney Howell

University of Manchester - Manchester Business School ( email )

Booth Street West
Manchester, M15 6PB
United Kingdom

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