Working Paper: CEPR ID: DP144
Authors: Marco Pagano
Abstract: Market thinness can be an important determinant of the riskiness of stock returns, because it reduces the reliability of stock prices as predictors of future dividends. This paper analyses the relationship between market size and risk as the outcome of rational expectations equilibrium in a multiasset model with transaction costs, and shows that: (i) the conditional and measured variance of stock returns should be higher for thin issues ceteris paribus, and (ii) this thinness-variability relationship should arise only from the unsystematic component of the variance. These predictions are tested on data from the Milan Stock Exchange and appear to be supported by the evidence.
Keywords: market thinness; informational content of stock prices; variability of stock returns; unsystematic risk; transaction costs
JEL Codes: 026; 313
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| market thinness (D41) | conditional variance of stock returns (C46) |
| market thinness (D41) | unsystematic component of variance (C29) |
| unsystematic component of variance (C29) | conditional variance of stock returns (C46) |
| number of market participants (D41) | unsystematic risk (D80) |
| number of market participants (D41) | variance of observed asset returns (G17) |
| size of outstanding asset supply (E51) | variance of observed asset returns (G17) |