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Is Liquidity Self-Fulfilling?

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  • James Dow

    (London Business School)

Abstract

A security market where the relative incidence of informed and uninformed trading determines liquidity may have more than one equilibrium. Equilibrium with high liquidity has a low bid-ask spread. This increases participation by traders who want to hedge risk exposure, as opposed to trading on private information, and justifies the small price impact of trades. Equilibrium with low liquidity has a high bid-ask spread. This deters some hedgers, increasing the relative incidence of informed trading, which justifies the larger spread. This analysis casts doubt on the relevance of comparative statics results in the existing literature relying on exogenous liquidity traders.

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Bibliographic Info

Article provided by University of Chicago Press in its journal Journal of Business.

Volume (Year): 77 (2004)
Issue (Month): 4 (October)
Pages: 895-908

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Handle: RePEc:ucp:jnlbus:v:77:y:2004:i:4:p:895-908

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Web page: http://www.journals.uchicago.edu/JB/

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Cited by:
  1. Ozsoylev, Han N. & Takayama, Shino, 2010. "Price, trade size, and information revelation in multi-period securities markets," Journal of Financial Markets, Elsevier, Elsevier, vol. 13(1), pages 49-76, February.
  2. Stephen Morris & Hyun Song Shin, 2012. "Contagious Adverse Selection," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(1), pages 1-21, January.
  3. Foucault, Thierry & Kadan, Ohad & Kandel, Eugene, 2009. "Liquidity cycles and make/take fees in electronic markets," Les Cahiers de Recherche 920, HEC Paris.
  4. Afonso, Gara, 2011. "Liquidity and congestion," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 20(3), pages 324-360, July.
  5. Carvalho, Carlos & Klagge, Nicholas & Moench, Emanuel, 2011. "The persistent effects of a false news shock," Journal of Empirical Finance, Elsevier, Elsevier, vol. 18(4), pages 597-615, September.
  6. Biais, Bruno & Bisière, Christophe & Pouget, Sébastien, 2009. "Equilibrium Discovery and Preopening Mechanisms in an Experimental Market," IDEI Working Papers, Institut d'Économie Industrielle (IDEI), Toulouse 543, Institut d'Économie Industrielle (IDEI), Toulouse.
  7. Itay Goldstein & Assaf Razin, 2013. "Three Branches of Theories of Financial Crises," NBER Working Papers 18670, National Bureau of Economic Research, Inc.
  8. Christophe Chamley, 2005. "Complementarities in Information Acquisition with Short-Term Trades," Boston University - Department of Economics - Working Papers Series, Boston University - Department of Economics WP2005-027, Boston University - Department of Economics.

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