Market Liquidity: Theory, Evidence, and Policy

414 Pages·2013·3.558 MB·English

by  Thierry Foucault, Marco Pagano, Ailsa Röell

University Press Scholarship Online
Oxford Scholarship Online
Market Liquidity: Theory, Evidence, and Policy
Thierry Foucault, Marco Pagano, and Ailsa Roell
Print publication date: 2013
Print ISBN-13: 9780199936243
Published to Oxford Scholarship Online: September 2013
DOI: 10.1093/acprof:oso/9780199936243.001.0001
Title Pages
Market Liquidity Market Liquidity Market Liquidity
(p.iv)
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Library of Congress Cataloging-in-Publication Data
Foucault, Thierry. Market liquidity: theory, evidence, and policy /
Thierry Foucault, Marco Pagano, Ailsa Röell.
p. cm.
Includes bibliographical references and index.
ISBN 978-0-19-993624-3 (cloth: alk. paper)
1. Liquidity (Economics) 2. Securities. 3. Capital market. I. Pagano,
Marco.
II. Röell, Ailsa, 1955- III. Title.
HG178.F64 2013
332′.041-dc23
2012030772
ISBN 978-0-19-993624-3
1 3 5 7 9 8 6 4 2
Printed in the United States of America
Title Pages
on acid-free paper
Dedication
University Press Scholarship Online
Oxford Scholarship Online
Market Liquidity: Theory, Evidence, and Policy
Thierry Foucault, Marco Pagano, and Ailsa Roell
Print publication date: 2013
Print ISBN-13: 9780199936243
Published to Oxford Scholarship Online: September 2013
DOI: 10.1093/acprof:oso/9780199936243.001.0001
Dedication
(p.v) To our families (p.vi)
Preface
University Press Scholarship Online
Oxford Scholarship Online
Market Liquidity: Theory, Evidence, and Policy
Thierry Foucault, Marco Pagano, and Ailsa Roell
Print publication date: 2013
Print ISBN-13: 9780199936243
Published to Oxford Scholarship Online: September 2013
DOI: 10.1093/acprof:oso/9780199936243.001.0001
(p.xii) Preface
Liquid markets enable people to fund investments that require a long-term commitment
of wealth, while retaining the opportunity to access that wealth when needed. In this way
liquidity facilitates real investment and enhances economic growth. But market liquidity
can be elusive at times, as investors discovered to their cost in the recent financial crisis
—a forcible reminder of John Maynard Keynes’s 1936 warning that “there is no such
thing as liquidity of investment for the community as a whole” (p. 155): markets freeze
when everyone is seeking liquidity and no one is willing to provide it.
Aim and Structure of the Book
The central topic of this book is the liquidity of security markets: its determinants and its
effects. The first part of the book (Chapters 1 through 5) provides the reader with basic
modeling and econometric tools needed to understand market microstructure, the area
of financial economics that focuses on security market liquidity. This part of the book
starts by describing how security markets are organized and how their liquidity can be
measured. Then we explain how various market imperfections affect price formation,
liquidity, and speed of price discovery. Finally, we show how the interaction of order flow
and price movements can be used to assess empirically the relative importance of
various determinants of liquidity.
Preface
The second part of the book investigates how key features of market design affect the
level of liquidity, the speed of price discovery, and gains and losses to market
participants: we examine limit order book markets with continuous trading (Chapter 6),
and the issues of fragmentation (Chapter 7) and transparency (Chapter 8).
The third part of the book is devoted to interactions between market microstructure,
asset pricing, and corporate finance. We first explain how (p.xiii) liquidity affects the
returns required by investors, and therefore asset prices. Next, we examine how prices
in illiquid markets may diverge from underlying long-run values, especially in the context
of market freezes and financial crises (Chapter 9). The book concludes by explaining how
liquidity affects real investment decisions and corporate policies (Chapter 10).
The book provides an introduction to the field of market microstructure, covering
theory, empirical work, and policy issues. It is designed as a textbook for intermediate
and graduate-level students in economics and finance, as well as for practitioners with
some economics training. The level of technical complexity is kept to a minimum, so that
only a very basic knowledge of calculus, statistics, and game theory is necessary to tackle
the material. The book does not aim to be a comprehensive survey of the field, but a
unified and self-contained treatment of the core concepts and techniques in an area that
has greatly developed in the last thirty years. As the book is intended to be a teaching
and learning tool, each chapter starts with a list of learning objectives—major points that
the student can expect to master by working through the chapter. Most chapters also
include boxes that describe business stories or quotes from the financial press that
illustrate the real-world relevance of the concepts and results presented. The book also
comes with a generous supply of exercises, which vary in complexity and focus: some of
them require analytical derivations; others ask for empirical work on small data sets
provided on the book’s companion web site (which also contains supplemental teaching
material for registered educators); see http://www.oup.com/us/marketliquidity/. Our
experience is that hands-on practice with the end-of-chapter exercises is the best way to
master the material in the book.
How to Use the Book
We can say with some confidence that this is a useful book, having taught from
preliminary versions of it over the years. Indeed, we have greatly benefited from the
feedback received over more than a decade from undergraduate and graduate students
at HEC Paris, Imperial College, Tinbergen Institute, and at the universities of Bologna,
Mannheim, Naples, Princeton, Sydney, and Tilburg. The book can be used as the main
source of material for a course in market microstructure or as a complement to other
books in other areas of finance.
A course that covers the entire book would require thirty to forty lecture hours,
depending on the background of the students (plus about ten one-hour exercise
sessions). However, the book is designed to allow a “modular” use of its material: by a
careful selection of chapters, it can be adapted to either an introductory course in market
microstructure pitched at the level of an (p.xiv) advanced undergraduate or master
class, or a more specialized and advanced course, possibly at the doctoral level. More
Preface
specifically, here are some examples of typical courses that can be designed by “slicing
and dicing” the material in the book:
(i) For a basic course in market microstructure we would recommend including
all of Part I (fifteen to twenty lecture hours depending on students’ background).
The chapters on the institutional setting (Chapter 1) and the basic theory of price
determination (Chapter 3) are essential. The theory of market depth (Chapter 4)
is highly recommended, although a short course might leave out the sections on
imperfect competition. A basic empirical training is provided by the chapters on
the measurement of liquidity and on estimating the determinants of liquidity
(Chapters 2 and 5). If more time is available, any of the subsequent chapters
(from Parts II and III) may be covered: each of them is self-contained, so that
they can be chosen in any combination that caters to the interests of the course
participants. Each additional chapter would require no less than three lecture
hours.
(ii) A master-level course on the architecture of securities markets would start
with the basic institutions and theory (Chapters 1, 3, and 4) and then focus on the
market design and regulatory issues addressed in Part II (Chapters 6, 7, and 8).
Such a course would require fifteen to twenty lecture hours.
(iii) A master-level or Ph.D. course stressing the relevance of market
microstructure for asset pricing and corporate finance should include Chapters 3,
4, 9, and 10 (twelve to fifteen hours).
(iv) A suitable complement for a Ph.D. course in asset pricing would include
Chapters 3 and 9.
(v) Similarly, to complement a Ph.D. course in corporate finance, we suggest
Chapters 3 and 10.
Acknowledgments
This book has been many years in the writing, as our students, colleagues, and family
members know only too well. We have accumulated a large debt of gratitude. We would
like to thank the colleagues, coauthors, and mentors who inspired and encouraged our
work in the area. A partial list includes Viral Acharya, Anat Admati, Alessandro Beber,
Bruno Biais, Patrick Bolton, Margaret Bray, Giovanni Cespa, Hans Degryse, Peter
Diamond, Andrew Ellul, Laurent Fresard, Alessandro Frino, Thomas Gehrig, Larry
Glosten, Charles Goodhart, Oliver Hart, Joel Hasbrouck, Martin Hellwig, Johan Hombert,
Charles Jones, Frank de Jong, Ohad Kadan, Eugene Kandel, Mervyn King, Pete Kyle,
Albert (p.xv) Menkveld, Sophie Moinas, Theo Nijman, Maureen O’Hara, Christine
Parlour, Ioanid Rosu, Patrik Sandas, Duane Seppi, Chester Spatt, Ernst-Ludwig von
Thadden, Erik Theissen, David Thesmar, Dimitri Vayanos, Paolo Volpin, and Josef
Zechner.
We are particularly grateful to Alessandro Beber for providing data, to Andrew Ellul for
both data and extensive feedback on the manuscript, and to Lorenzo Pandolfi for his
invaluable advice and his painstaking work on the exercises. We also thank the graduate
students who at various stages provided valuable feedback and assistance: Gennaro
Preface
Catapano, Chin-Han Chiang, Dincbas Neslihan, Francesco Paolo Conteduca, Sarah Draus,
Maurizio Montone, Roberto Pinto, Jean-David Sigaux, Yuehua Tang, Antoine Thabault,
and especially Paul Whelan.
Special mention goes to Roger Meservey for his outstanding copyediting of the entire
manuscript. The striking cover was designed by Paola Pagano, who took the book literally
as an inspiration to freeze a few liquid assets. We also thank Terry Vaughn and Joe
Jackson at Oxford University Press for their encouragement and guidance during the
preparation of the manuscript.
Over the years, our research for this book was supported by our respective employers:
École des Hautes Études Commerciales de Paris, Università di Napoli Federico II,
Imperial College London, and Columbia University’s School of International and Public
Affairs. Extended periods of joint work on the book were generously hosted by the Italian
Academy for Advanced Studies at Columbia University, the Studienzentrum Gerzensee,
the Einaudi Institute for Economics and Finance, and the Toulouse School of Economics.
Last but not least, we thank Anne, Carla, and Patrick for their support and their patience
in putting up with the countless hours we stole from family time to work on this
enterprise.
Introduction
University Press Scholarship Online
Oxford Scholarship Online
Market Liquidity: Theory, Evidence, and Policy
Thierry Foucault, Marco Pagano, and Ailsa Roell
Print publication date: 2013
Print ISBN-13: 9780199936243
Published to Oxford Scholarship Online: September 2013
DOI: 10.1093/acprof:oso/9780199936243.001.0001
Introduction
Thierry Foucault
Marco Pagano
Ailsa Röell
DOI:10.1093/acprof:oso/9780199936243.003.0001
Abstract and Keywords
This introductory chapter begins with an overview of what this book is about. It identifies
two key concepts in market microstructure—market liquidity and price discovery—and
explains why these are important. It then outlines some puzzling phenomena in securities
markets and concludes with a discussion of the three dimensions of liquidity.
Keywords: market microstructure, market liquidity, price discovery, securities markets
Learning Objectives:
• What is this book about?
• Two key concepts in market microstructure: market liquidity and price discovery