Is Liquidity Self-Fulfilling?
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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