Abstract
We propose a model of price formation in which the trading price varies only if the value of the information signal is large enough to guarantee a profit in excess of transaction costs. Using transaction data only, we extract: (i) the conditional volatility of the underlying security, which is thus cleaned out by market frictions, (ii) an estimate of transaction costs. Our analysis reveals that, after correcting for frictions, the risk of illiquid securities is substantially different from what predicted by traditional volatility models. Furthermore, in periods of high volatility, our estimate of transaction costs remains highly correlated with bid-ask spreads, whereas alternative illiquidity proxies, such as the fraction of zero returns, loose their explanatory power.
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