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Liquidity Risk, Speculative Trade, and the Optimal Latency of Financial Markets

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  • Fricke, Daniel
  • Gerig, Austin

Abstract

Garbade and Silber (1979) demonstrate that an asset will be liquid if it has (1) low price volatility and (2) a large number of public investors who trade it. Although these results match nicely with common notions of liquidity, one key element is missing: liquidity also depends on (3) an asset s correlation with other securities. For example, if an illiquid asset is highly correlated with a liquid asset, then speculators will naturally step in and make it liquid . In this paper, we update Garbade and Silber s model to include an infinitely liquid market security. We show that when the market security is added, the liquidity of the non-market asset is still a decreasing function of volatility and an increasing function of investor participation, but it is now also an increasing function of its correlation with the market. Furthermore, we show that at a critical correlation value of 0.86, it is optimal for the asset to continuously clear, i.e., for orders to transact immediately when placed in the market. This low-latency result holds regardless of the other properties of the asset. The updated model can help answer several questions relevant to current financial markets: How and why do short-term speculators provide liquidity in markets? , How much benefit do these speculators add? , and Can extremely low-latency in markets be beneficial?

Suggested Citation

  • Fricke, Daniel & Gerig, Austin, 2014. "Liquidity Risk, Speculative Trade, and the Optimal Latency of Financial Markets," VfS Annual Conference 2014 (Hamburg): Evidence-based Economic Policy 100402, Verein für Socialpolitik / German Economic Association.
    • Handle: RePEc:zbw:vfsc14:100402
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    More about this item

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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