Trading constraints and illiquidity discounts

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.