Imposed trading constraints act as an exogenous source of illiquidity, prevent free trading of restricted shares and make them be priced at a discount relative to their freely-traded counterparts with identical dividends and voting rights from the same listed firms. This paper numerically solves the theoretical illiquidity discounts for the case of long constraint horizons and then reconciles the contradictions in the results of various frameworks by identifying the effects of the unlimited and costless borrowings assumed in Longstaff (2001). 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 virtually the largest population of restricted shares worldwide. Large discounts are documented in two forms of 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 significant as the transfers are made privately and may be subject to price manipulation when the involved parties are related.

We examine the effect of illiquidity discount on stock prices on the warrants prices in China. We construct measures of liquidity based on market microstructure models, and find that they explain a significant portion of the cross-section variation in the warrants pricing biases and implied stock discounts in the market. We conclude that, due to the T+1 rule in Chinese stock market, equity market is illiquid relative to the warrants market that doesn’t bear the T+1 rule. This imposed illiquidity cause the discount on the stock price, which is not reflected in the warrants market. Thus the illiquidity in stock market contributes to the pricing bias in warrants market.

We investigate considerations (compensations) paid in on-going Division Reform, a process of releasing trading constraint, in China Stock Market, and link this event with existing literature of restricted asset by inferring implied illiquidity discount of restricted shares from consideration. We also propose a new measure of restriction capturing multiple dimensions of restriction finding it together with the scale of restriction well explain the ratio of considerations and the implied illiquidity discount. We also use theoretical models to justify the 20% implied illiquidity discount and find it is below the 48.67% upper bound suggested by Longstaff (1995) and it falls within the range between 12.18% and 23.82% suggested by Lonstaff (2001) concluding the considerations paid in Division Reform is adequate and relative wealth of two classes of shareholders remains after the trading constraint released.

This paper provides evidence on the significant impact of illiquidity or non-marketability on security valuation. A typical listed company in China has several types of share outstanding: (i) common shares that are only tradable on stock exchanges, (ii) restricted institutional shares (RIS) that are not tradable and can only be transferred privately or through irregularly scheduled auctions, and (iii) state shares that are only transferable privately. These types of share are identical in every aspect, except that market regulations make state and RIS shares almost totally illiquid. Our analysis focuses on the price differences between RIS and common shares of the same company, using both auction and private-transfer transactions for RIS shares. Among our findings, the average discount for RIS shares relative to their floating counterpart is 77.93% and 85.59%, respectively based on auction and private transfers. The price for illiquidity is thus high, significantly raising the cost of equity capital. This illiquidity discount increases with both the floating shares’ volatility and the firm’s debt/equity ratio, but decreases with firm size, return on equity, and book/price and earnings/price ratios (based on the floating share price). However, RIS share price can either increase or decrease with the quantity being transacted, depending on whether it is through a private placement or an auction.