Presented at the Annual Meeting of the American Finance Association, 1996. This paper tests the effect on stock value of an expected change in future trading costs. The capitalized value of a reduction in trading costs is hypothesized to increase the stock value, a trading cost effect.
Improved liquidity reduces trading costs.
The abnormal return of eac h stock is regressed against the ratio of the bid-ask spread to the price of the stock, the change in trading volume of the stock, and the open interest in the Index futures contracts at the close of the month prior to the replacement announcement. We find that the positive abnormal returns for replacement stocks are related to increased daily trading volume after inclusion in the Index. Further, the trading cost effect is proportional to percentage bid-ask spreads prior to inclusion. The trading co st effect increases as trading in derivatives of the Index increases. The volume and stock price changes after replacement are not transitory, indicating an improvement in liquidity.