Working Paper: CEPR ID: DP146
Authors: Marco Pagano
Abstract: 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.
Keywords: stock price volatility; stock market size; thin financial markets; transaction costs; multiple equilibria; government intervention
JEL Codes: 022; 024; 026; 311; 313
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Thin markets (G19) | Increased volatility (E32) |
| Increased volatility (E32) | Exit of risk-averse investors (G19) |
| Exit of risk-averse investors (G19) | Thin markets (G19) |
| Thin markets (G19) | Exit of risk-averse investors (G19) |
| Incentive schemes (J33) | Increase in number of investors (G24) |
| Increase in number of investors (G24) | Reduced volatility (G19) |
| Reduced volatility (G19) | Higher supply of the asset (G19) |
| Higher supply of the asset (G19) | Increased stock prices (G19) |
| Increased stock prices (G19) | Induce firms to issue more equity (G24) |
| Market size (L25) | Price volatility (G13) |
| Government intervention (O25) | Shift from low-trade, high-volatility equilibrium to high-trade, low-volatility equilibrium (F12) |