Examine the link between imperfections in markets and a lack of liquidity.
The idea
In a frictionless market any quantity trades instantly at one price, so illiquidity cannot exist. It appears when imperfections are added. Search frictions in over-the-counter markets mean finding a counterparty takes time and gives dealers bargaining power, which widens spreads. Asymmetric information means dealers fear trading against better-informed counterparties, so they widen the spread to cover those losses. In extreme cases buyers withdraw altogether. Transaction costs and limited dealer capital reduce the volume a market can absorb. Funding constraints link the two kinds of liquidity. When margins rise, leveraged intermediaries and investors must cut positions, which lowers market liquidity, pushes prices down and tightens funding again in a spiral. The exam point is to name the specific imperfection behind each symptom, such as adverse selection for spreads and margins for spirals.
A practice question
In a perfectly frictionless market, which statement is true?
- Illiquidity is still present, because investors always need time to find a buyer.Why not: Time to find a buyer is a search friction, which is excluded in a frictionless market.
- Any quantity trades instantly at one price, so illiquidity does not arise. - correct
- Bid-ask spreads are positive but small, reflecting dealer profit.Why not: With no frictions, dealers earn no compensation for costs or information, so spreads are zero.
- Large orders move prices, but the effect is temporary.Why not: Price impact is itself a friction; with none, orders of any size do not move price.
Illiquidity is the result of imperfections such as costs, search and information gaps. Remove them and trades clear instantly at one price in any size.
A harder one
In an over-the-counter market without a central exchange, investors must locate counterparties and negotiate bilaterally. What is the most direct effect on liquidity?
- Price impact disappears, because every trade is negotiated individually.Why not: Negotiation does not remove price impact; it adds search costs on top of it.
- Spreads narrow, because dealers compete fiercely for every bilateral deal that is negotiated.Why not: Bilateral search limits competition and typically widens spreads.
- Liquidity is unaffected, because the number of potential buyers is unchanged.Why not: The number of buyers matters less than the cost and time needed to reach them, which search frictions raise.
- Search takes time and shifts bargaining power to dealers, widening spreads and lowering the price on a quick sale. - correct
Search frictions mean finding a counterparty is slow and costly. A seller in a hurry accepts a lower price, which is exactly what illiquidity means.
The hardest tier
An asset is worth either 105 or 95 with equal probability. A competitive dealer quotes prices at which expected profit is zero. 20 percent of traders are informed and always trade in line with the true value; the other 80 percent buy or sell with equal probability. The bid-ask spread (ask minus bid) is closest to:
- 2.0 - correct
- 1.0Why not: Reports the half-spread (ask minus the mid-price) rather than the full ask-bid spread.
- 6.0Why not: Multiplies the 10 value range by the 0.6 chance of a buy when the value is high, which is not the zero-profit quote.
- 8.0Why not: Uses the uninformed share (0.8) times the 10 value range instead of the informed share.
P(buy | 105) = 0.2 + 0.8 x 0.5 = 0.6 and P(buy | 95) = 0.4, so ask = 0.6 x 105 + 0.4 x 95 = 101. By symmetry bid = 99, so the spread is 2.0. It equals the informed share times the 10 value range.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Illiquid Assets
- Appraise the defining features of markets that are illiquid.
- Weigh up how biases affect the returns reported for illiquid assets.
- Account for how returns are unsmoothed and what unsmoothing does.
- Set the premiums paid for bearing illiquidity risk against each other, both across asset categories and within a single category.
- Appraise the consequences of putting illiquid assets into a portfolio, for rebalancing and trading as well as for deciding how large a proportion of them is optimal.