9.2 Why liquidity is important for the efficient allocation of costs Flashcards
Which kinds of markets tend to suffer from less liquidity?
Markets that are decentralised, such as over-the-counter (OTC) markets, or fractured, such as much of the corporate bond market.
What are the implicit and explicit ways markets with less liquidity are a disadvantage?
Lower levels of liquidity are a disadvantage:
- Explicitly – leaving investors unable to crystallise profits or limit losses.
- Implicitly – through the additional costs involved in the transaction.
What is liquidity risk?
Liquidity risk is the risk that an investor may be unable to sell an asset they own when they wish to do so at a price that is fair.
How does liquidity risk affect the securities market and derivatives market?
In the securities markets, this could leave an investor unable to crystallise a profit if their asset has risen in value but there are no willing buyers. It could also mean that they are left holding an asset that continues to fall in value, losing the investor more money.
These risks also exist in the derivatives markets, but there is the additional risk of unwanted delivery situations. If the investor is unable to close out a physically delivered derivative before the delivery date, they may be obliged to take or make delivery on the contract.
Explain the link between liquid markets and efficient pricing.
Liquid markets, with many buyers and sellers, tend to have efficient price discovery, where the price at which the asset trades is the price agreed upon by many well-informed participants. Having all prices displayed on order driven platforms, such as the London Stock Exchange’s SETS platform, adds to the clarity in pricing and the certainty of receiving the best price available. Illiquid markets, typically, do not have this level of transparency.
Explain the relationship between liquid markets and transaction costs.
Liquid markets not only contribute to the efficiency in pricing but also incur lower transaction costs. These could be costs built into a bid offer spread and/or additional cost imposed through broker/adviser fees. Where markets are illiquid, the spreads tend to be wider and the additional costs higher. These higher costs are to compensate those making a market for the additional risk caused by the uncertainty in pricing and the possibility of being unable to exit any position they enter into with their clients.
When considering the returns generated through an investment. What is it common for an investor to forget to consider?
Investors may forget to consider the transaction costs involved in generating that profit. These additional costs can significantly erode the returns.
Name the 2 categories of costs suffered.
- Implicit
- Explicit
Explain 3 impicit costs.
- Bid/offer spreads on the market itself – the less liquid and/or more risky the asset, the wider the spread.
- The price impact of the trade – large orders may shift the market price as they are being executed. Sometimes just the information about a potential large order may shift the market price.
- Opportunity cost – the price move that could occur as you wait for your order to be executed.
Name 4 explicit costs
- Broker/adviser fees to gain access to the market
- Stamp duty reserve tax (SDRT) charged at 0.5% on purchases of chargeable securities
- Takeover Panel levy of £1 charged on all LSE transactions above £10,000
- Foreign exchange rate movements if investing in a foreign currency
What is the formula for percentage increase?
% inc = new number/old number - 1 × 100
An investor buys 2,000 shares quoted at £4.70/£4.78 on the 10th July. Six months later the shares are sold at a market price quoted at £5.10/£5.22. The investor’s broker charges a commission of 0.75% on all trades. Assume no dividends were paid during the holding period. After considering all costs, including Stamp duty reserve tax (SDRT) and the Takeover Panel levy, what is the investor’s return?
Without costs
The investor’s return would be:
• Cost of shares = 2,000 x £4.78 = £9,560
• Proceeds from sale of shares = 2,000 x £5.10 = £10,200
• Total return = £10,200 / £9,560 - 1 = 6.69%
Note: Even here, there is the cost implied by the spread on the quote.
With costs
Total cost of purchase
• Cost of shares = 2,000 x £4.78 = £9,560
• PLUS
• Broker’s commission = £9,560 x 0.0075 = £71.70
• (SDRT) = £9,560 x 0.005 = £47.80
• Total cost = £9,560 + £71.70 + £47.80 = £9,679.50
Net proceeds on the sale
• Proceeds from sale of shares = 2,000 x £5.10 = £10,200
• MINUS
• Broker’s commission = £10,200 x 0.0075 = £76.50
• Takeover panel levy = £1
• Net proceeds = £10,200 - £76.50 - £1 = £10,122.50
Total return after all costs = £10,122.50 / £9,679.50 - 1 = 4.58%
What costs need to be considered in relation to the venue?
When factoring in not only the trade, but also clearing, settlement and custody. Execution on a multilateral trading facility (MTF) typically takes up a much lower proportion of the total cost than, for example, executing on the London Stock Exchange. Overall cost is also likely to be lower using a multilateral trading facility (MTF). These additional costs are likely to be the trade-off for better implicit costs, e.g. quicker execution and lower price impact due to the depth of the market.
What costs need to be considered in relation to the size of order?
We have already mentioned the implicit impact on price of the size of the order, but size can work to your advantage. Often commissions are reduced depending on the size of the trade. In the gilt market, for example, orders below £5,000 nominal value typically incur a higher commission charge than those above £5,000, while purchases in excess of £1m attract no commission charge.
What costs need to be considered in relation to over-the-counter (OTC)?
Due to the bespoke nature of the contracts negotiated OTC, the costs are typically considerably higher than for exchange-traded contracts.
