Market Liquidity: Theory, Evidence, and Policy

Hardcover | March 6, 2013

byThierry Foucault, Marco Pagano, Ailsa Roell

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The way in which securities are traded is very different from the idealized picture of a frictionless and self-equilibrating market offered by the typical finance textbook. Market Liquidity offers a more accurate and authoritative take on liquidity and price discovery. The authors start fromthe assumption that not everyone is present at all times simultaneously on the market, and that even the limited number of participants who are have quite diverse information about the security's fundamentals. As a result, the order flow is a complex mix of information and noise, and a consensusprice only emerges gradually over time as the trading process evolves and the participants interpret the actions of other traders. Thus a security's actual transaction price may deviate from its fundamental value, as it would be assessed by a fully informed set of investors. This book takes these deviations seriously, and explains why and how they emerge in the trading process and are eventually eliminated. The authors draw on a vast body of theoretical insights and empirical findings on security price formation that have accumulated in the last thirty years, and havecome to form a well-defined field within financial economics known as "market microstructure." Focusing on liquidity and price discovery, they analyze the tension between the two, pointing out that when price-relevant information reaches the market through trading pressure rather than through apublic announcement, liquidity suffers. The book also confronts many puzzling phenomena in securities markets and uses the analytical tools and empirical methods of market microstructure to understand them. These include issues such as why liquidity changes over time, why large trades move prices up or down, and why these price changesare subsequently reversed, why we see concentration of securities trading, why some traders willingly disclose their intended trades while others hide them, and why we observe temporary deviations from arbitrage prices.

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The way in which securities are traded is very different from the idealized picture of a frictionless and self-equilibrating market offered by the typical finance textbook. Market Liquidity offers a more accurate and authoritative take on liquidity and price discovery. The authors start fromthe assumption that not everyone is present a...

Thierry Foucault is Professor of Finance at the HEC Paris International Business School. Marco Pagano is Professor of Economics at the University of Naples Federico II. Ailsa Roell is Professor of International and Public Affairs at Columbia University.

other books by Thierry Foucault

Format:HardcoverDimensions:464 pages, 9.25 × 6.12 × 0.98 inPublished:March 6, 2013Publisher:Oxford University PressLanguage:English

The following ISBNs are associated with this title:

ISBN - 10:0199936242

ISBN - 13:9780199936243

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Table of Contents

PrefaceIntroduction0.1 What is this book about?0.2 Why should we care?0.3 Some puzzles0.4 The three dimensions of liquidity0.4.1 Market liquidity0.4.2 Funding liquidity0.4.3 Monetary liquidityI Institutions1. Market structure and trading mechanics1.1 Introduction1.2 Limit order markets and dealer markets1.2.1 Limit order markets1.2.2 Dealer markets1.2.3 Hybrid markets1.2.4 Market transparency1.3 Does market structure matter?1.4 Evolution of market structure1.4.1 Who makes the rules?1.4.2 Competition between exchanges1.4.3 Automation1.5 Further reading1.6 Exercises2. Measuring liquidity2.1 Introduction2.2 Measures of the spread2.2.1 The quoted spread2.2.2 The effective spread2.2.3 The realized spread2.3 Other measures of implicit trading costs2.3.1 Volume-weighted average price2.3.2 Measures based on price impact2.3.3 Non-trading measures2.3.4 Measures based on return covariance2.4 Implementation shortfall2.5 Hands-on estimation of transaction costs2.6 Further reading2.7 Appendix2.8 Exercises3. Order flow, liquidity and securities price dynamics3.1 Introduction3.2 Price dynamics and the efficient market hypothesis3.3 Price dynamics with informative order flow3.3.1 The Glosten-Milgrom model3.3.2 The determinants of the bid-ask spread3.3.3 How do dealers revise their quotes?3.4 Price dynamics with order-processing costs3.4.1 Bid-ask spread with order-processing costs3.4.2 Price dynamics with order-processing and adverse-selection costs3.5 Price dynamics with inventory risk3.5.1 A two-period model3.5.2 A multi-period model3.5.3 The dynamics of prices and inventories3.6 The full picture3.7 Further reading3.8 Exercises4. Trade size and market depth4.1 Introduction4.2 Market depth under asymmetric information4.2.1 Learning from order size4.2.2 Perfectly competitive dealers4.2.3 Informed trader's order placement strategy4.2.4 Imperfectly competitive dealers4.3 Market depth with inventory risk4.3.1 Perfectly competitive dealers4.3.2 Imperfectly competitive dealers4.4 Further reading4.5 Appendix A4.6 Appendix B4.7 Exercises5. Estimating the determinants of market illiuidity5.1 Introduction5.2 Price impact regressions5.2.1 Without inventory costs5.2.2 With inventory costs5.3 Measuring the permanent impact of trades5.4 Probability of informed trading (PIN)5.5 Further reading5.6 ExercisesII Market Design and Regulation6. Limit order book markets6.1 Introduction6.2 A model of the limit order book (LOB)6.2.1 The market environment6.2.2 Execution probability and order submission cost6.2.3 Limit order trading with informed trading6.3 Design of LOB markets6.3.1 Tick size6.3.2 Priority rules6.3.3 Hybrid LOB markets6.4 The make or take decision in LOB markets6.4.1 Risk of being picked off and risk of non execution6.4.2 Bid-ask spreads and execution risk6.4.3 Bid-ask spreads and volatility6.4.4 Indexed limit orders, monitoring, and algorithmic trading6.4.5 Order flow and the state of the LOB6.5 Further reading6.6 Exercises7. Market fragmentation7.1 Introduction7.2 The Costs of fragmentation7.2.1 Information effects7.2.2 Risk-sharing effects7.2.3 Competition among liquidity suppliers7.2.4 Fragmentation and the broker-client relationship7.3 Liquidity externalities7.3.1 Liquidity begets liquidity7.3.2 Low-liquidity traps7.4 The benefits of fragmentation7.4.1 Curbing the pricing power of exchanges7.4.2 Sharper competition among liquidity providers7.4.3 Trade-throughs7.5 Regulation7.5.1 Regulation NMS7.5.2 MiFID7.6 Further reading7.7 Exercises8. Market transparency8.1 Pre-trade transparency8.1.1 Quote transparency and competition between dealers8.1.2 Quote transparency and execution risk8.1.3 Order flow transparency8.2 Post-trade transparency8.3 Revealing trading motives8.4 Why are markets so opaque?8.4.1 Rent extraction and lobbying8.4.2 Opacity can withstand competition8.4.3 The bright side of opacity8.5 Further reading8.6 ExercisesIII Implications for Asset Prices, Financial Crises and Corporate Policies9. Liquidity and Asset Prices9.1 Introduction9.2 Illiquidity and asset prices9.2.1 The illiquidity premium9.2.2 Clientele effects9.2.3 Evidence9.2.4 Asymmetric information, illiquidity and asset returns9.2.5 Illiquidity premia in OTC markets9.3 Liquidity risk and asset prices9.4 Liquidity and limits to arbitrage9.4.1 Risk of early liquidation as a limit to arbitrage9.4.2 Limited speculative capital as a barrier to arbitrage9.4.3 Implications for market making and liquidity crises9.5 Correlated order flow and noise trader risk9.6 Further reading9.7 Appendix. The derivation of the search model9.8 Exercises10. Liquidity, price discovery and corporate policies10.1 Introduction10.2 Market liquidity and corporate investment10.3 Market liquidity and corporate governance10.4 Price discovery, corporate investment and executive compensation10.4.1 Stock prices and investment allocation10.4.2 Stock prices and executive compensation10.5 Corporate policies and market liquidity10.5.1 Listing and cross-listing10.5.2 Designated market makers10.5.3 Disclosure policy10.5.4 Capital structure10.6 Further reading10.7 ExercisesReferencesIndex