generally, "the ability to trade large size quickly, @ low cost, when you want to trade"
Speed of execution, Bid/ask spreads & other costs for small orders, Depth of Market - slope of demand/supply, Resilience - how quickly prices bounce back
Interest in trading an asset (average vol), Costs of trading an asset, Private information about asset's value, More private information means less liquidity
Private information about asset's value
Number of analysis, Clarity of accounting statements, Recent news events, Insider transactions
Dealers set spreads in equilibrium, Cover their costs, Inventory financing, Wages, dues, research, settlement, etc, Adverse selection - losing on average to better informed traders, Dealers make 0 economic profit,
Transaction costs component (transitory), Adverse selection component (Permanent),
Transaction costs component
Covers most of the costs of dealers, Without informed traders, the only component, Can be measured with bid/ask bounce, Also called inventory adjustment
Adverse selection component
Dealers trade against informed traders, lose money to them, Calculate the prob that order is informed when they see buy order, Must set spreads so that they are selling @ conditional expected value, Dealer must charge AS spread to break even
Usually find that adverse selection is_____ than transaction costs component
Reducing asymmetric information...
reduces bid/ask spread or increases liquidity
More liquidity means...
Several things reduce asymmetric info
Require employees to trade in defined periods, Disclose all news to all investors promptly, Give good, accurate guidance, Good Investor Relations group
Strong systematic component to liquidity - market liquidity crunches happen, sometimes this due to asymmetric info, subprime crisis
First, one large investor gets a call, liquidates positions that other investors hold, prices move against others, more margin calls, no one can trade b/c there is no capital
Crash of 1987
Options traders appear to have been culprit, To create an index put, as prices fell they sold, Specialists @ NYSE walked away from their posts (first and last time), Could not post limit orders w/o losing, Circuit breakers were created in response
are compensated on average
Liquidity providers (market makers)
When compensation _______, markets can seize up and be dysfunctional