Trade-off of Short-Term Trading: Liquidity vs. Efficiency Shyam Sunder, Yale University Governance and Regulation in Financial Markets and Institutions.

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Presentation transcript:

Trade-off of Short-Term Trading: Liquidity vs. Efficiency Shyam Sunder, Yale University Governance and Regulation in Financial Markets and Institutions Society for Socio-Economics London, July 3, 2015

Liquidity Price movement caused by a trade of a given size as a measure of market liquidity (there are others, mostly related to this one) Widely considered a desirable characteristic of markets Allows investors to trade readily, and at low cost Perfect liquidity is synonymous with perfect markets

How Do We Increase Liquidity? Readiness and ability of a large number of traders to trade large volumes often High turnover ratio Lower holding periods Larger number of transfers of a security during its life time (till maturity) In other words: short investment horizons

Investment Horizons What is the effect of the length of investment horizons on pricing efficiency (correspondence between price of the security and its fundamental value)? Shorter the investment horizons, less efficient are the markets in pricing securities Experimental results

Overlapping Generations Experimental Design 5 Treat- ment Period # of Subjects End of 16 T1 5 G0 5 G1D T2 5 G0 5 G1 5 G2D T4 5 G0 5 G1 5 G2 5 G3 5 G4D T8 5 G0 5 G1 5 G2 5 G3 5 G4 5 G5 5 G6 5 G7 5 G8D Notes: D means that the last generation of investors receives terminal dividends (50) at the end of Period 16.

Summary of results (low Liquidity) 6

Summary of results (high Liquidity) 7

Summary of Results Shorter investment horizons cause prices to deviate more from fundamental values (lower pricing efficiency)

The Trade-off Two desired properties of markets – Liquidity – Pricing efficiency But shorter investment horizons are necessary for high liquidity Shorter investment horizons also reduce pricing efficiency There is a trade-off between the two; can’t increase both at the same time

Thank You! research.html