The Price Of Liquidity

This open access book addresses four standard business school subjects: microeconomics, macroeconomics, finance and information systems as they relate to trading, liquidity, and market structure. It provides a detailed examination of the impact of trading costs and other impediments of trading that the authors call rictions It also presents an interactive simulation model of equity market trading, TraderEx, that enables students to implement trading decisions in different market scenarios and structures. Addressing these topics shines a bright light on how a real-world financial market operates, and the simulation provides students with an experiential learning opportunity that is informative and fun. Each of the chapters is designed so that it can be used as a stand-alone module in an existing economics, finance, or information science course. Instructor resources such as discussion questions, Powerpoint slides and TraderEx exercises are available online.

This book explores the effect of liquidity on asset prices, liquidity variations over time and how liquidity risk affects prices.

Liquidity and Asset Prices reviews the literature that studies the relationship between liquidity and asset prices. The authors review the theoretical literature that predicts how liquidity affects a security's required return and discuss the empirical connection between the two. Liquidity and Asset Prices surveys the theory of liquidity-based asset pricing followed by the empirical evidence. The theory section proceeds from basic models with exogenous holding periods to those that incorporate additional elements of risk and endogenous holding periods. The empirical section reviews the evidence on the liquidity premium for stocks, bonds, and other financial assets.

Professional investors are bombarded on a day to day basis with assertions about the role liquidity is playing and will play in determining prices in the financial markets. Few, if any, of the providers or recipients of such advice can truly claim to understand the well–springs of such liquidity and the transmission mechanisms through which it impacts asset prices. This groundbreaking new book explores the belief that at the core of liquidity there is a force which exerts individuals to effect a financial transaction when they would not otherwise do so. Understanding this force of compulsion is a key to understanding a financial market when it appears to be behaving irrationally. This book will enable new and seasoned investors to develop an understanding of the factors, so that costly mistakes can be avoided without the lesson of experience.

This book presents the theory and evidence on the effect of market liquidity and liquidity risk on asset prices and on overall securities market performance. Illiquidity means incurring a high transaction cost, which includes a large price impact when trading and facing a long time to unload a large position. Liquidity risk is higher if a security becomes more illiquid when it needs to be traded in the future, which will raise trading cost. The book shows that higher illiquidity and greater liquidity risk reduce securities prices and raise the expected return that investors require as compensation. Aggregate market liquidity is linked to funding liquidity, which affects the provision of liquidity services. When these become constrained, there is a liquidity crisis which leads to downward price and liquidity spiral. Overall, the volume demonstrates the important role of liquidity in asset pricing.

We identify frictions in the market for liquidity as well as bank-specific and market-wide factors that affect the prices that banks pay for liquidity, captured here by borrowing rates in repos with the central bank and benchmarked by the overnight index swap. We have price data at the individual bank level and, unique to this paper, data on individual banks' reserve requirements and actual reserve holdings, thus allowing us to gauge the extent to which a bank is short or long liquidity. We find that the price a bank pays for liquidity depends on the liquidity positions of other banks, as well as its own. There is evidence that liquidity squeezes occasionally occur and short banks pay more the larger is the potential for a squeeze. The price paid for liquidity is decreasing in bank size and small banks are more adversely affected by an increased potential for a squeeze. Healthier banks pay less, but contrary to what one might expect, banks in formal liquidity networks do not.

Brings together today's best financial minds across the world to discuss the issue of liquidity in today's markets. It is often proxied by trade-based measures (such as trading volume, frequency of trading, dollar value of shares trade, etc), order based measures and price impact measures.