Liquidity

Question 1

What are 3 sources of liquidity?

Answer 1

1. Search friction for a counterparty.
2. Bid-ask spread.
3. Price impact.

Question 2

What are 2 characteristics of liquidity?

Answer 2

1. Tightness: small trades enquire small costs (bid-ask spread).
2. Depth: Big trades do not affect prices.

Question 3

What are three types of intermediaries on financial markets?

Answer 3

1. Quote-Driven Dealers: Market Makers quote prices and by at these prices. They hold inventory of securities. They make money with the Bid-Ask Spread.
2. Order-Driven Markets: No intermediation, more like a classical auction or market exchange.
3. Brokered Markets: Brokers match two opposite sides, do not hold inventory.

Question 4

What are the three types of priority rules w.r.t oder execution?

Answer 4

1. Price Priority: Best priced order executes first.
2. Time Priority: First entered trade executes first.
3. Size Priority: Larger gets executed first.

Question 5

What are the two types of market transparency?

Answer 5

Pre and Post-Trade.

Question 6

What are the two components of the bid-ask spread?

Answer 6

1. Permanent component to compensate for cost of doing business.
2. Adverse-Selection Component to compensate for the uncertainty and asymmetric information.

Question 7

Where does the trading risk for the market maker come from?

Answer 7

They do not research the fundamental value of securities, but trade with people who do.

Question 8

What does the Glosten and Milgrom Model of the Bid-Ask spread tell us about it?

Answer 8

It is proportional to the proportion of informed traders.

Question 9

Draw the Glosten and Milgrom Tree of Trading Possibilities.

Answer 9

Question 10

What does the Glosten and Milgrom Model of the Bid-Ask spread tell us about security value in the long-run?

Answer 10

That all the information is eventually revealed to reflect the true price.

Question 11

How does Amihud define Price Impact illiquidity?

Answer 11

Average daily absolute return over daily volatility.

Question 12

What do Chan and Lakonishok find about the price inmpact of large investment managers?

Answer 12

Positive price impact of buys and negative price impact of sales.

Question 13

What do Frazzini, Israel and Moskovitz find about price impact?

Answer 13

On average, the price impact was of 12.18 bp, with 70% of it remaining after the trade happened.W

Question 14

What is the effect on trading costs of increased tracking error acceptance?

Answer 14

A Higher tracking error reduces the number of needed trade and so reduces the total trading cost.

Question 15

What is the relationship between returns and liquidity?

Answer 15

There is an inverse relationship after controlling for Beta, Size, past returns, etc.

Question 16

Slides 54-61 Kibo?

Question 17

In the Glosten and Milgrom model, what is the formula for the bid-ask spread?

Answer 17

(Val. High - Val. Low)*[P(Val. High | Sell) - P(Val. High | Buy)]

Question 18

What is the formula for P(Val. High | Sell)?

Answer 18

Question 19

What is the formula for P(Val. High | Buy)?

Answer 19