Market Liquidity: Theory, Evidence, and Policy

Preface
Introduction
0.1 What is this book about?
0.2 Why should we care?
0.3 Some puzzles
0.4 The three dimensions of liquidity
0.4.1 Market liquidity
0.4.2 Funding liquidity
0.4.3 Monetary liquidity
I Institutions
1 Market structure and trading mechanics
1.1 Introduction
1.2 Limit order markets and dealer markets
1.2.1 Limit order markets
1.2.2 Dealer markets
1.2.3 Hybrid markets
1.2.4 Market transparency
1.3 Does market structure matter?
1.4 Evolution of market structure
1.4.1 Who makes the rules?
1.4.2 Competition between exchanges
1.4.3 Automation
1.5 Further reading
1.6 Exercises
2 Measuring liquidity
2.1 Introduction
2.2 Measures of the spread
2.2.1 The quoted spread
2.2.2 The effective spread
2.2.3 The realized spread
2.3 Other measures of implicit trading costs
2.3.1 Volume-weighted average price
2.3.2 Measures based on price impact
2.3.3 Non-trading measures
2.3.4 Measures based on return covariance
2.4 Implementation shortfall
2.5 Hands-on estimation of transaction costs
2.6 Further reading
2.7 Appendix
2.8 Exercises
3 Order flow, liquidity and securities price dynamics
3.1 Introduction
3.2 Price dynamics and the efficient market hypothesis
3.3 Price dynamics with informative order flow
3.3.1 The Glosten-Milgrom model
3.3.2 The determinants of the bid-ask spread
3.3.3 How do dealers revise their quotes?
3.3.4 Price discovery
3.3.5 The implications for price movements and volatility
3.4 Price dynamics with order-processing costs
3.4.1 Bid-ask spread with order-processing costs
3.4.2 Price dynamics with order-processing and adverse-selection costs
3.5 Price dynamics with inventory risk
3.5.1 A two-period model
3.5.2 A multi-period model
3.5.3 The dynamics of prices and inventories
3.6 The full picture
3.7 Further reading
3.8 Exercises
4 Trade size and market depth
4.1 Introduction
4.2 Market depth under asymmetric information
4.2.1 Learning from order size
4.2.2 Perfectly competitive dealers
4.2.3 Informed trader's order placement strategy
4.2.4 Imperfectly competitive dealers
4.3 Market depth with inventory risk
4.3.1 Perfectly competitive dealers
4.3.2 Imperfectly competitive dealers
4.4 Further reading
4.5 Appendix A
4.6 Appendix B
4.7 Exercises
5 Estimating the determinants of market illiquidity
5.1 Introduction
5.2 Price impact regressions
5.2.1 Without inventory costs
5.2.2 With inventory costs
5.3 Measuring the permanent impact of trades
5.4 Probability of informed trading (PIN)
5.5 Further reading
5.6 Exercises
II Market Design and Regulation
6 Limit order book markets
6.1 Introduction
6.2 A model of the limit order book (LOB)
6.2.1 The market environment
6.2.2 Execution probability and order submission cost
6.2.3 Limit order trading with informed trading
6.3 Design of LOB markets
6.3.1 Tick size
6.3.2 Priority rules
6.3.3 Hybrid LOB markets
6.4 The make or take decision in LOB markets
6.4.1 Risk of being picked off and risk of non execution
6.4.2 Bid-ask spreads and execution risk
6.4.3 Bid-ask spreads and volatility
6.4.4 Indexed limit orders, monitoring, and algorithmic trading
6.4.5 Order flow and the state of the LOB
6.5 Further reading
6.6 Exercises
7 Market fragmentation
7.1 Introduction
7.2 The Costs of fragmentation
7.2.1 Information effects
7.2.2 Risk-sharing effects
7.2.3 Competition among liquidity suppliers
7.2.4 Fragmentation and the broker-client relationship
7.3 Liquidity externalities
7.3.1 Liquidity begets liquidity
7.3.2 Low-liquidity traps
7.4 The benefits of fragmentation
7.4.1 Curbing the pricing power of exchanges
7.4.2 Sharper competition among liquidity providers
7.4.3 Trade-throughs
7.5 Regulation
7.5.1 Regulation NMS
7.5.2 MiFID
7.6 Further reading
7.7 Exercises
8 Market transparency
8.1 Pre-trade transparency
8.1.1 Quote transparency and competition between dealers
8.1.2 Quote transparency and execution risk
8.1.3 Order flow transparency
8.2 Post-trade transparency
8.3 Revealing trading motives
8.4 Why are markets so opaque?
8.4.1 Rent extraction and lobbying
8.4.2 Opacity can withstand competition
8.4.3 The bright side of opacity
8.5 Further reading
8.6 Exercises
III Implications for Asset Prices, Financial Crises and Corporate Policies
9 Liquidity and Asset Prices
9.1 Introduction
9.2 Illiquidity and asset prices
9.2.1 The illiquidity premium
9.2.2 Clientele effects
9.2.3 Evidence
9.2.4 Asymmetric information, illiquidity and asset returns
9.2.5 Illiquidity premia in OTC markets
9.3 Liquidity risk and asset prices
9.4 Liquidity and limits to arbitrage
9.4.1 Risk of early liquidation as a limit to arbitrage
9.4.2 Limited speculative capital as a barrier to arbitrage
9.4.3 Implications for market making and liquidity crises
9.5 Correlated order flow and noise trader risk
9.6 Further reading
9.7 Appendix. The derivation of the search model
9.8 Exercises
10 Liquidity, price discovery and corporate policies
10.1 Introduction
10.2 Market liquidity and corporate investment
10.3 Market liquidity and corporate governance
10.4 Price discovery, corporate investment and executive compensation
10.4.1 Stock prices and investment allocation
10.4.2 Stock prices and executive compensation
10.5 Corporate policies and market liquidity
10.5.1 Listing and cross-listing
10.5.2 Designated market makers
10.5.3 Disclosure policy
10.5.4 Capital structure
10.6 Further reading
10.7 Exercises
References
Index

Thierry Foucault is Professor of Finance, HEC Paris International Business School. Marco Pagano is Professor of Economics, University of Naples Federico II. Ailsa Roëll is Professor of International and Public Affairs, Columbia University.