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Liquidity Trading and Price Determination in Equit
B2C Commerce Merchant (University of Oxford)
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Liquidity, Trading, and Price
Determination in Equity Markets: 2
A Finance Course Application
The relationship between fundamental information and the price of equity shares is
critically important. Fundamental information encompasses a vast array of items
that pertain to individual firms, to industries, and to the broad, macro economy. In
investment courses, the relationship is considered with respect to portfolio forma-
tion. In corporate finance, the relationship is considered with respect to asset valua-
tions and the determination of a firm’s cost of capital.
The transformation of fundamental information into share prices starts with the
information set and extends to investors (both individual and institutional) and then
to the marketplace where equity shares are traded and share prices determined. In so
doing, fundamental information is transformed into three factors: (1) expected
future returns, (2) uncertainty concerning future returns (an investment’s risk), and
(3) the difficulty of buying and selling shares in the market (liquidity risk).
In broad brush, this is how it works. Assume that a stock’s expected 1-year for-
ward price is $55 a share. If shares are currently priced at $50, the expected return
on the investment is 10%. If, concurrently, the risk-free rate of interest is 4%, the
stock is priced to yield a 6% premium. What accounts for the premium? Two things:
risk and illiquidity.
Risk exists because what a stock’s actual price will be one year from now is
unknown in the present. The stock’s expected share price is $55. One year later, the
price could turn out to be nicely higher than $55 or disappointingly lower. Thus, the
investment is risky, and very importantly, investors are risk averse. Accordingly, the
premium compensates them for accepting risk. But is that all it compensates inves-
tors for? No, investors are also averse to illiquidity.
Risk pertains to a future share value, while illiquidity matters when shares are
bought or sold. Here is a simple, intuitive definition of what the term liquidity
means: the ability to buy or to sell shares reasonably quickly, in reasonable amounts,
and at reasonable prices. In a frictionless environment, the market would be
perfectly liquid, trading would be costless, and shares could be bought or sold
© The Author(s) 2022 21
D. Ozenbas et al., Liquidity, Markets and Trading in Action, Classroom
Companion: Business, https://doi.org/10.1007/978-3-030-74817-3_2
Downloaded by olinder seth ()
, lOMoARcPSD|59658805
22 2 Liquidity, Trading, and Price Determination in Equity Markets: A Finance Course…
instantly at an appropriate price. But equity markets are not frictionless,1 trading is
not at all costless (we explain more about this in Sect. 2.2), and transaction costs are
higher the more illiquid a market is.
Let us back up for a moment. How are investors compensated for risk? By a risk
premium. How are they compensated for buying shares that they know can be dif-
ficult to sell in the future? By an illiquidity premium. Accordingly, let us repeat:
with the risk-free rate at 4%, buying shares at $50 while expecting a 1-year forward
price of $55 yields a premium of 6%, and this premium compensates investors both
for accepting risk and for bearing the cost of illiquidity.
So what is liquidity? As we have just said, a good intuitive definition of this
slippery term is the ease with which shares can be traded. Can they be traded
quickly? Can they be traded in reasonable quantity and at a reasonable price? If
the answer is yes, yes, yes, then we can say that the market for a company’s
shares is liquid. But what benchmark might there be for assessing, for an order
of a given number of shares, the time taken to fill it and the price at which the
trade has been made? And can the assessments of time, price, and size be aggre-
gated into a single quantitative measure of liquidity? They cannot, so where do
we stand? Hang on, we return to a further discussion of liquidity in Sect. 2.7 of
this chapter.
For most stocks, speed is not an issue in today’s modern electronic markets.
What about size? Size is not an issue for smaller, retail-sized orders, but it is a major
challenge for institutional-sized orders (for instance, an order of 50,000 shares,
100,000 shares, or more). What about price? Have you observed how rapidly prices
change in short, intraday intervals? They bounce around, often with such rapidity
that you can look at a price one instant, blink, and then look again and the stock’s
share value has changed. Clearly, in this environment, trading at a “reasonable”
price is difficult to accomplish, and it is not even easy to know what a reasonable
price is.
One glance at a computer screen with “real-time” prices will convince you of
this. At times, price rises (or falls) over a series of trades, turns direction, and then
shoots back down (or up). What might explain this volatility? Finding prices that
best reflect the broad market’s desire to hold shares is complex and dynamic. The
process is called price discovery. We pursue this thought further in Sect. 2.4 of this
chapter.
Buying and selling shares is clearly not costless. Costs exist in the form of com-
missions and fees. They also exist for a participant who wants to consummate a
trade quickly by buying or selling “at market” because there is a spread between the
price at which one can buy shares (the lowest posted asking quote on the market)
and the price at which one can sell shares (the highest posted bid quote on the mar-
ket). The difference between the best buy and the best sell quotes is the bid-ask
1
Friction is the total implicit and explicit costs associated with the execution of a financial
transaction.
Downloaded by olinder seth ()
Liquidity Trading and Price Determination in Equit
B2C Commerce Merchant (University of Oxford)
Scan to open on Studocu
Studocu is not sponsored or endorsed by any college or university
Downloaded by olinder seth ()
, lOMoARcPSD|59658805
Liquidity, Trading, and Price
Determination in Equity Markets: 2
A Finance Course Application
The relationship between fundamental information and the price of equity shares is
critically important. Fundamental information encompasses a vast array of items
that pertain to individual firms, to industries, and to the broad, macro economy. In
investment courses, the relationship is considered with respect to portfolio forma-
tion. In corporate finance, the relationship is considered with respect to asset valua-
tions and the determination of a firm’s cost of capital.
The transformation of fundamental information into share prices starts with the
information set and extends to investors (both individual and institutional) and then
to the marketplace where equity shares are traded and share prices determined. In so
doing, fundamental information is transformed into three factors: (1) expected
future returns, (2) uncertainty concerning future returns (an investment’s risk), and
(3) the difficulty of buying and selling shares in the market (liquidity risk).
In broad brush, this is how it works. Assume that a stock’s expected 1-year for-
ward price is $55 a share. If shares are currently priced at $50, the expected return
on the investment is 10%. If, concurrently, the risk-free rate of interest is 4%, the
stock is priced to yield a 6% premium. What accounts for the premium? Two things:
risk and illiquidity.
Risk exists because what a stock’s actual price will be one year from now is
unknown in the present. The stock’s expected share price is $55. One year later, the
price could turn out to be nicely higher than $55 or disappointingly lower. Thus, the
investment is risky, and very importantly, investors are risk averse. Accordingly, the
premium compensates them for accepting risk. But is that all it compensates inves-
tors for? No, investors are also averse to illiquidity.
Risk pertains to a future share value, while illiquidity matters when shares are
bought or sold. Here is a simple, intuitive definition of what the term liquidity
means: the ability to buy or to sell shares reasonably quickly, in reasonable amounts,
and at reasonable prices. In a frictionless environment, the market would be
perfectly liquid, trading would be costless, and shares could be bought or sold
© The Author(s) 2022 21
D. Ozenbas et al., Liquidity, Markets and Trading in Action, Classroom
Companion: Business, https://doi.org/10.1007/978-3-030-74817-3_2
Downloaded by olinder seth ()
, lOMoARcPSD|59658805
22 2 Liquidity, Trading, and Price Determination in Equity Markets: A Finance Course…
instantly at an appropriate price. But equity markets are not frictionless,1 trading is
not at all costless (we explain more about this in Sect. 2.2), and transaction costs are
higher the more illiquid a market is.
Let us back up for a moment. How are investors compensated for risk? By a risk
premium. How are they compensated for buying shares that they know can be dif-
ficult to sell in the future? By an illiquidity premium. Accordingly, let us repeat:
with the risk-free rate at 4%, buying shares at $50 while expecting a 1-year forward
price of $55 yields a premium of 6%, and this premium compensates investors both
for accepting risk and for bearing the cost of illiquidity.
So what is liquidity? As we have just said, a good intuitive definition of this
slippery term is the ease with which shares can be traded. Can they be traded
quickly? Can they be traded in reasonable quantity and at a reasonable price? If
the answer is yes, yes, yes, then we can say that the market for a company’s
shares is liquid. But what benchmark might there be for assessing, for an order
of a given number of shares, the time taken to fill it and the price at which the
trade has been made? And can the assessments of time, price, and size be aggre-
gated into a single quantitative measure of liquidity? They cannot, so where do
we stand? Hang on, we return to a further discussion of liquidity in Sect. 2.7 of
this chapter.
For most stocks, speed is not an issue in today’s modern electronic markets.
What about size? Size is not an issue for smaller, retail-sized orders, but it is a major
challenge for institutional-sized orders (for instance, an order of 50,000 shares,
100,000 shares, or more). What about price? Have you observed how rapidly prices
change in short, intraday intervals? They bounce around, often with such rapidity
that you can look at a price one instant, blink, and then look again and the stock’s
share value has changed. Clearly, in this environment, trading at a “reasonable”
price is difficult to accomplish, and it is not even easy to know what a reasonable
price is.
One glance at a computer screen with “real-time” prices will convince you of
this. At times, price rises (or falls) over a series of trades, turns direction, and then
shoots back down (or up). What might explain this volatility? Finding prices that
best reflect the broad market’s desire to hold shares is complex and dynamic. The
process is called price discovery. We pursue this thought further in Sect. 2.4 of this
chapter.
Buying and selling shares is clearly not costless. Costs exist in the form of com-
missions and fees. They also exist for a participant who wants to consummate a
trade quickly by buying or selling “at market” because there is a spread between the
price at which one can buy shares (the lowest posted asking quote on the market)
and the price at which one can sell shares (the highest posted bid quote on the mar-
ket). The difference between the best buy and the best sell quotes is the bid-ask
1
Friction is the total implicit and explicit costs associated with the execution of a financial
transaction.
Downloaded by olinder seth ()
