DP146 Endogenous Market Thinness and Stock Price Volatility

Author(s): Marco Pagano
Publication Date: December 1986
Keyword(s): Stock Market, Stock Prices, Thin Financial Markets, Transaction Costs, Volatility
JEL(s): 022, 026, 311, 313
Programme Areas: International Macroeconomics, Applied Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=146

Thin equity markets cannot accommodate temporary bulges of buy or sell orders without large price movements: the resulting volatility can induce risk-averse transactors who face transaction costs to desert these markets altogether. Thus thinness and the consequent price volatility may become joint self-perpetuating features of an equity market, whatever the volatility of asset fundamentals. If, however, appropriate incentive schemes are adopted to encourage entry of additional investors, this vicious circle can be broken, eventually shifting the market to a self-sustaining, superior equilibrium, characterized by a higher number of transactors, lower price volatility and larger supply of the asset.