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Is Liquidity Self-Fulfilling?

Author

Listed:
  • 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.

Suggested Citation

  • James Dow, 2004. "Is Liquidity Self-Fulfilling?," The Journal of Business, University of Chicago Press, vol. 77(4), pages 895-908, October.
    • Handle: RePEc:ucp:jnlbus:v:77:y:2004:i:4:p:895-908
    DOI: 10.1086/422628
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    Citations

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    Cited by:

    1. Gara Minguez Afonso, 2008. "Liquidity and Congestion," 2008 Meeting Papers 926, Society for Economic Dynamics.
    2. Ozsoylev, Han N. & Takayama, Shino, 2010. "Price, trade size, and information revelation in multi-period securities markets," Journal of Financial Markets, Elsevier, vol. 13(1), pages 49-76, February.
    3. Goldstein, Itay & Razin, Assaf, 2015. "Three Branches of Theories of Financial Crises," Foundations and Trends(R) in Finance, now publishers, vol. 10(2), pages 113-180, 30.
    4. Carvalho, Carlos & Klagge, Nicholas & Moench, Emanuel, 2011. "The persistent effects of a false news shock," Journal of Empirical Finance, Elsevier, vol. 18(4), pages 597-615, September.
    5. Afonso, Gara, 2011. "Liquidity and congestion," Journal of Financial Intermediation, Elsevier, vol. 20(3), pages 324-360, July.
    6. Strobl, Günter, 2022. "A theory of procyclical market liquidity," Journal of Economic Dynamics and Control, Elsevier, vol. 138(C).
    7. Gábor Pintér & Chaojun Wang & Junyuan Zou, 2021. "Size Discount and Size Penalty Trading Costs in Bond Markets," Discussion Papers 2114, Centre for Macroeconomics (CFM).
    8. Stephen Morris & Hyun Song Shin, 2010. "Contagious Adverse Selection - Revised November, 2010," Working Papers 1282, Princeton University, Department of Economics, Econometric Research Program..
    9. Krista Schwarz, 2019. "Mind the Gap: Disentangling Credit and Liquidity in Risk Spreads," Review of Finance, European Finance Association, vol. 23(3), pages 557-597.
    10. Thierry Foucault & Ohad Kadan & Eugene Kandel, 2013. "Liquidity Cycles and Make/Take Fees in Electronic Markets," Journal of Finance, American Finance Association, vol. 68(1), pages 299-341, February.
    11. Farhi, Emmanuel & Tirole, Jean, 2015. "Liquid bundles," Journal of Economic Theory, Elsevier, vol. 158(PB), pages 634-655.
    12. Stephen Morris & Hyun Song Shin, 2012. "Contagious Adverse Selection," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(1), pages 1-21, January.
    13. Bruno Biais & Christophe Bisière & Sébastien Pouget, 2014. "Equilibrium Discovery and Preopening Mechanisms in an Experimental Market," Management Science, INFORMS, vol. 60(3), pages 753-769, March.
    14. Daniel G Arce & Kevin Siqueira, 2014. "Motivating operatives for suicide missions and conventional terrorist attacks," Journal of Theoretical Politics, , vol. 26(4), pages 677-695, October.
    15. David Musto & Greg Nini & Krista Schwarz, 2018. "Notes on Bonds: Illiquidity Feedback During the Financial Crisis," The Review of Financial Studies, Society for Financial Studies, vol. 31(8), pages 2983-3018.
    16. Glebkin, Sergei & Kuong, John Chi-Fong, 2023. "When large traders create noise," Journal of Financial Economics, Elsevier, vol. 150(2).
    17. Chen-Yu Chen & Jian-Hsin Chou & Hung-Gay Fung & Yiuman Tse, 2017. "Setting the futures margin with price limits: the case for single-stock futures," Review of Quantitative Finance and Accounting, Springer, vol. 48(1), pages 219-237, January.
    18. Bond, Philip & Dow, James, 2021. "Failing to forecast rare events," Journal of Financial Economics, Elsevier, vol. 142(3), pages 1001-1016.
    19. Zheng, Zhigang & Tang, Ke & Liu, Yaodong & Guo, Jie Michael, 2021. "Gender and herding," Journal of Empirical Finance, Elsevier, vol. 64(C), pages 379-400.
    20. Christophe Chamley, 2005. "Complementarities in Information Acquisition with Short-Term Trades," Boston University - Department of Economics - The Institute for Economic Development Working Papers Series dp-156, Boston University - Department of Economics.
    21. Martin Walther & Marco Bade, 2020. "Observational learning and willingness to pay in equity crowdfunding," Business Research, Springer;German Academic Association for Business Research, vol. 13(2), pages 639-661, July.
    22. Christophe Chamley, 2005. "Complementarities in Information Acquisition with Short-Term Trades," Boston University - Department of Economics - Working Papers Series WP2005-027, Boston University - Department of Economics.

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