The Price Impact of Trades in Illiquid Stocks in Periods of High and Low Market Activity

Abstract

While the majority of market microstructure studies deals with the behavior of frequently traded stocks, the focus of this paper is on illiquid securities listed on the NYSE. Using high frequency data on ten infrequently traded stocks during the year 1999, we measure the information content of a trade and the relation to the trading intensity. We establish several results. While the price impact curve for frequently traded stocks (such as IBM) monotonically increases towards the full information price, we find impulse response functions that first 'overshoot' and subsequently decrease towards the full information price. The overshooting effect strongly depends upon the bid-ask spread and the trading intensity. Furthermore, we show that the difference in price impact between periods of slow and fast trading is much larger for illiquid stocks than for frequently traded stocks. This emphasizes that the information content of the trading intensity of infrequently traded stocks is larger than for liquid stocks. Finally, we explicitly model the overnight behavior of the trading intensity and returns. We show that for infrequently traded stocks it may take several days before the full information price that follows a trade is attained. Moreover, the adjustment time crucially depends upon the bid-ask spread and the trading intensity.

Keywords: Infrequently Traded Stocks, Price Impact, Trading Costs, Trading Intensity, Durations, Market Microstructure, Asymmetric Information, Inventory Effects

JEL Classification: C41, G14