L3 - Liquidity

Question 1

basic concepts

Answer 1

important ?

• time to get a transaction (execution time)
• index (should stock be incl. or not?)
• asset pricing
• market competitiveness

Question 2

liquidity

definition

Answer 2

“easy to identify when seen, but difficult to define”
closer related to volatility than to returns the
ability to buy or sell significant quantities of a security quickly, anonymously
and with minimal or no price impact
implications on:
- transparency (lit vs dark pools)
- speed (HFT)
- LOB (depth, QSp)

Question 3

liquidity

focus on instant and forget about information

Answer 3

A) immediacy cost:
relative spread, difference between best bid and offer

b) Depth Volume at LOB
min. Volume needed o change prices
amount of shares/money available in the books

Question 4

quoted bid-ask spread

Answer 4

cost of directly trading at the liquidity provider quoted prices instead of introducing a LO
immediacy cost

cost of buying and immed. selling stock you loose money - hence cost (or profit)

Question 5

Behaviour:

Answer 5

START
high spread low depth
inside trading - privilege information (some know exact price of stock but other don´t)

inside trading at beg. of day is very high, but when firm discloses info (price is more efficient)
hence only way to avoid this is increase spread

END:
low spread, high volume
institutional investors closing transaction in the last minute
volume is important, but not directly related to depth (As depth is the shares available in the LOB)

Question 6

Liquidity measure

Answer 6

immediacy costs exhibit usual patter
a) RSWT:
L shape intraday pattern
minimum at central hours or end ?

b) DWT:
progressively increases until last two trading hours, but smoothly decreases ?

trading activity during first interval is related with informed trading
quoted midpoint is more sensible o order flows
higher expected information-motivated activity

Question 7

Components of QSp

Answer 7

a) adverse selection costs
asymmetric information among Market participants (inside traders will make profit)

b) inventory costs
cost of MM when providing liquidity to the market
dealer fixed a spread to control the risk of accumulating large inventory

c) order processing costs:
equipment and personnel (fixed noninfor. costs, operation costs)

high inventory, high costs, high spread

Question 8

Asymmetric Information models

sequential trade models

Answer 8

randomly selected traders arrive at market
singly, sequentially, independently,

dealer establishes his profit max. spread by balancing expected total revenues from liquidity trading vs . expected loss from informed trading

implications:
- B/A spread increases with volatility, higher asset price level, lower volume
- rational dealer with always set:
a) higher ask
b) lower bid than he believes ‘true market price’ to be

Question 9

sequential trade models

Glosten Milgrom Model

Answer 9

adverse selection by itself account for the existence of a spread between bid and ask
average magnitude depends:
- exogenous arrival pattern of insiders and liquidity traders
- elasticity of S&D among liquidity traders
- quality of information held by insiders

80`s model assume that informed traders only trade with market orders, unrealistic in LOB markets
GM models proves that an important component of spread is due to adv. selection

Question 10

Liquidity over years

Answer 10

liquidity has impove over the yeas
spread has decreased (spec. introduction of algorithmic trading ? )
presence of algo &elect. trading and machines have decreased volume, shares of trading
decrease depth
but higher average message/min sent
pc001 (cancelling orders per cent of 1 second?) - quadratic form
depthtickbest - amount of money available at best quotes spreads (best bid/ask)

Question 11

Main drivers of Quoted and Effective Spreads

Answer 11

suppliers of immediacy (MM or liquidity providers) are passive traders who stand ready to trade at price they quote

demanders of immediacy - active trades who actually place MO to trade immediately

immediate sales are usually made at bid price
immediate purchase at he ask price

Question 12

Variables affective spread

Answer 12

cross-sectional relation of spreads to firms trading charact. is strong and has changed little over time: 
dollar volume (log)
return variance
stocks market cap 
stocks closing price
number of trades per day

higher volume –> smaller spread - HIGH L
higher Volatiliy –> large spread - LOW L
higher market cap –> larger spread - LOW L
higher price (larger firms)–> smaller spread - HIGH L

Question 13

UFA

ultra-fas activity

Answer 13

relationship: UFA and Market Quality
using standard. variables, after eliminating asset spec. variables (mean and var)

variables affecting liquidity:

• MOIMB = (Vol buy - Vol sell) in one-min interval
• VOLATM = average realised volatility in last 30 min
• PC100 - nr. of LO posted within 100 ms cancelled