LiquidityPreshita Chaurasiya

PGDM 2013030

LIQUIDITY

The ability to trade large size quicklyLow cost and at time when you want to tradeCharacteristic of well functioning financial marketEveryone likes Liquidity• Traders – implement trading strategies• Exchanges – attracts traders to their markets• Regulators – liquid markets are less volatile than illiquid

Search for Liquidity

Unilateral Search• Good match-good price• General rule- find general benefit from additional inquiry > expected

cost of inquiry• Decision- when to stop the search• Outcome- luck or skill of the searcher

Bilateral Search• Differs in 2 aspects from Unilateral: Active or Passive and Best Result• Active- try to find matches• Passive- wait for others to find them• You may not be able to return to the best match you previously

identified• Cost of continuing must include the loss of previous best match• Impatient Traders – Active Traders – demand liquidity• Patient Traders – Passive Traders – supply liquidity• Reduction in search costs

Example: Dance Strategies

• Dancers- 3 Strategies• 1st – Most interested – directly ask potential partners• 2nd – Others display interest – wait for others to ask• Judge partner before accepting• 3rd – Wallflowers – Neither ask nor show interest• May dance only if they like the match

Liquidity Dimensions• Immediacy- QUICKLY- given size- given cost• Width- COST of trade- given size• Depth- SIZE of trade- given cost• Resiliency- QUICKLY- prices revert to former levels changed due to large tradesLiquidity Trade-offs

CHANGE HOLDING CONSTANT IMPLICATION

Spend more time searching Size of trade Expect to find a better average price

Price you are willing to pay/ receive

Expect to find more size

Increase size of desired trade Time spent searching Expect to find a worse average price

Price Expect to spend more time searching

Offer a better price Size of trade Expect to spend less time searching

Time spent searching Expect to find more size

Characteristic trader Characteristic strategy Effect on Liquidity

Market Makers Publish quotes Offer immediacy

Block Dealers Large deals Supply depth

Value Traders Informed trader Ultimate depth suppliers

Precommitted traders Standing limit orders Offer immediacy

Arbitrageurs Trade on price differences Increase Market depth

Liquidity Suppliers

THANK YOU!