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Does Liquidity Affect Securities Market Efficiency?

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  • Tetlock, Paul C.
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    Abstract

    I investigate the impact of liquidity on market efficiency using data from short-horizon binary outcome securities traded on an online exchange. I show that the most liquid securities markets exhibit significant pricing anomalies, such as overpricing low probability events and underpricing high probability events, whereas less liquid markets do not exhibit these anomalies. I also find that the prices of illiquid securities converge more quickly toward their terminal cash flows. These results are consistent with the idea that liquidity is a proxy for non-informational or noise trading, which can impede market efficiency; but they are inconsistent with models in which increases in liquidity have no impact or a favorable impact on efficiency.

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    Bibliographic Info

    Paper provided by Regulation2point0 in its series Working paper with number 159.

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    Date of creation: Nov 2006
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    Handle: RePEc:reg:wpaper:159

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    1. Gjerstad, S. & Dickhaut, J., 1995. "Price Formation in Double Auctions," Papers 284, Minnesota - Center for Economic Research.
    2. Bruno Jullien & Bernard Salanie, 2000. "Estimating Preferences under Risk: The Case of Racetrack Bettors," Journal of Political Economy, University of Chicago Press, vol. 108(3), pages 503-530, June.
    3. Camerer, Colin F & Ho, Teck-Hua, 1994. "Violations of the Betweenness Axiom and Nonlinearity in Probability," Journal of Risk and Uncertainty, Springer, vol. 8(2), pages 167-96, March.
    4. Wolfers, Justin & Zitzewitz, Eric, 2004. "Prediction Markets," Research Papers 1854, Stanford University, Graduate School of Business.
    5. Alok Kumar & Charles M.C. Lee, 2006. "Retail Investor Sentiment and Return Comovements," Journal of Finance, American Finance Association, vol. 61(5), pages 2451-2486, October.
    6. Friedman, Daniel & Ostroy, Joseph, 1995. "Competitivity in Auction Markets: An Experimental and Theoretical Investigation," Economic Journal, Royal Economic Society, vol. 105(428), pages 22-53, January.
    7. Noussair, Charles & Robin, Stephane & Ruffieux, Bernard, 1998. "The effect of transaction costs on double auction markets," Journal of Economic Behavior & Organization, Elsevier, vol. 36(2), pages 221-233, August.
    8. Cason, Timothy N. & Friedman, Daniel, 1996. "Price formation in double auction markets," Journal of Economic Dynamics and Control, Elsevier, vol. 20(8), pages 1307-1337, August.
    9. Jeffrey Wurgler & Ekaterina Zhuravskaya, 2000. "Does Arbitrage Flatten Demand Curves for Stocks?," Yale School of Management Working Papers ysm152, Yale School of Management, revised 01 Nov 2001.
    10. Gode, Dhananjay K & Sunder, Shyam, 1993. "Allocative Efficiency of Markets with Zero-Intelligence Traders: Market as a Partial Substitute for Individual Rationality," Journal of Political Economy, University of Chicago Press, vol. 101(1), pages 119-37, February.
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    Cited by:
    1. Fernando Lefort & Fernando Diaz, 2013. "Macroeconomic Stability, Financial Risks and Market Eciency: Evidence for a Small and Open Economy," Working Papers 45, Facultad de Economía y Empresa, Universidad Diego Portales.

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