Abstract:     
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 tansferred privately or through irregularly scheduled auctions, and (iii) state shares that are only transferable privately. These types of share are indentical 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.