What do you think?
Rate this book
Market Liquidity: Theory, Evidence, and Policy
The way in which securities are traded is very different from the idealized picture of a frictionless and self-equilibrating market offered by the typical finance textbook. In Market Liquidity, Thierry Foucault, Marco Pagano, and Ailsa R?ell offer a more accurate take on the liquidity of securities markets, its determinants, and its effects. They start from the assumption that not everyone is present at all times simultaneously on the market, and that even the limited number of participants who are have quite diverse information about the security's fundamentals. As a result, the order flow is a complex mix of information and noise, and a consensus price only emerges gradually over time as the trading process evolves and the participants interpret the actions of other traders. Thus, a security's actual transaction price may deviate from its fundamental value, as it would be assessed by a fully informed set of investors.
Market Liquidity takes these deviations seriously, and explains why and how they emerge in the trading process and are eventually eliminated. Drawing on the analytical tools and empirical methods from a well-defined field within financial economics--market microstructure--the authors confront many striking phenomena in securities markets, from liquidity changes over time to temporary deviations from asset fair values.
In the fully revised second edition of Market Liquidity, Foucault, Pagano, and R?ell bring readers up to speed on recent changes in market structures and financial regulation. New chapters cover the relationship between financial instability and market liquidity, as well as the role and effects of algorithmic and high-frequency trading. Including new illustrative examples of market malfunction and novel insights from recent research on security markets, Market Liquidity provides a comprehensive and authoritative account on market microstructure.
Market Liquidity takes these deviations seriously, and explains why and how they emerge in the trading process and are eventually eliminated. Drawing on the analytical tools and empirical methods from a well-defined field within financial economics--market microstructure--the authors confront many striking phenomena in securities markets, from liquidity changes over time to temporary deviations from asset fair values.
In the fully revised second edition of Market Liquidity, Foucault, Pagano, and R?ell bring readers up to speed on recent changes in market structures and financial regulation. New chapters cover the relationship between financial instability and market liquidity, as well as the role and effects of algorithmic and high-frequency trading. Including new illustrative examples of market malfunction and novel insights from recent research on security markets, Market Liquidity provides a comprehensive and authoritative account on market microstructure.
530 pages, Kindle Edition
First published February 25, 2013
20 people are currently reading
97 people want to read
Ratings & Reviews
Friends & Following
Create a free account to discover what your friends think of this book!
Community Reviews
Displaying 1 - 3 of 3 reviews
November 11, 2016
Liquidity can mean a bunch of things. In Economics it’s to do with the money supply and it’s been studied by the likes of Fisher, Keynes and Hicks, all the way to Milton Friedman. In corporate finance it’s to do with the amount of money a firm keeps on hand; given the role (the lack of) liquidity played in the crash of 2008, when firms sold anything that wasn’t nailed to the floor to get their hands on cash, it’s been studied quite extensively too, including by giants like Jean Tirole.
This pioneering book is about a third type of liquidity: the impact of a transaction on the price of an asset. In particular, the authors concern themselves with liquidity in the equities market.
I’ve spent a quarter century trading bonds, rather than stocks. Bonds trade on voice, mainly, so it’s quasi-impossible for academics to study bond liquidity. I’d therefore never bothered to read the literature.
That was my loss!
So in my previous job I designed and implemented a market-making algorithm for government bonds based on the “skewed inventory” principle that people use in FX. My colleague Bernard and I had advertised our ability to do this to our employers, but in reality we did not crack the problem until we’d spent a good three months on it, often despairing we’d come up with something reasonable.
You can imagine my surprise when I saw the exact answer we came up with on page 150 of this book, which has been in print since 2013. I guess fixed income is a total backwater when it comes to formalizing how liquidity works. That’s my excuse, at any rate :-)
The book is split into three parts:
The first part is a survey of methods to calculate the right bid-ask for a trade. It starts simple and naïve and slowly builds in all the necessary components:
• a charge to compensate for some of the flow being, ahem, “informed”
• a charge (or rebate) for the fact that the trade will alter your inventory
• finally, drumroll please, your “rent”
The converse is covered too: How to go from observing the ticker tape to estimating what the market is charging for all of the above. I loved this part of the book, it made it worth the purchase.
The second part of the book covers “Market Design” and should be required reading for all regulators, commentators, for Michael Lewis wannabes etc. You find out that the dealers win if tick size is large, what volatility does to bid-ask (clue: it does not make it easy to quote), it explains what the “Flash Boys” do (with the best explanation ever of Regulation NMS) and generally speaking it’s “all you ever wanted to know about rent extraction but were afraid to ask.”
The third part of the book explores another very important aspect of liquidity: the fact that lack of liquidity can stand in the way of asset prices reaching their equilibrium. I’m close to Andrei Shleifer, but I’d never read the paper where he explains mathematically why “the market can stay irrational for longer than you can stay solvent.” The authors do a tremendous job of laying it all out, taking you through the logical steps of how arbitrageurs can be forced to liquidate good positions before the market does it for them. Bravo! They close the book by taking you through the latest theories regarding the impact of liquidity on corporate governance.
So what we have here is a potential five-star book, but it is marred by some schoolboy errors that will hopefully disappear from future editions. I’d forgive the authors if those mistakes had not cost me so much time to discover. I list them here to save you from scratching your head:
pp. 87-93 the authors confuse themselves for no reason. The spread in equation 3.12 can be derived trivially, but it needs to be imposed on the post-information mid, the one after we know if the customer wanted to buy or sell. So at the bottom of p. 93 where the authors say ASKt = MUt+ and BIDt = MUt- that’s plain wrong. You need to add the half-spread to MUt+ to get to ASKt and you need to subtract the half-spread from MUt- to get to BIDt.
p. 109 it’s wrong to say that Yt = Dt, it’s –Dt. But two wrongs make a right (think about it) and formula 3.45 a bit further down is correct.
p. 139 contrary to the claim the formulae do not describe the volatility in response to an uninformed trade. They describe the volatility in response to mixed flow of informed and uninformed trades.
Finally (and this is not really a mistake) on page 167 the author gets all the math right, but fails to draw a conclusion that could be super-helpful to arguments made in the second part of the book: the dealer rent may well wash out of the correlation, but it sure hurts the client’s back pocket!
Regardless of these mistakes, I thoroughly enjoyed this book and recommend it to anybody who wants to understand market liquidity. Don’t be scared, the math is totally within the grasp of a good high school student!
This pioneering book is about a third type of liquidity: the impact of a transaction on the price of an asset. In particular, the authors concern themselves with liquidity in the equities market.
I’ve spent a quarter century trading bonds, rather than stocks. Bonds trade on voice, mainly, so it’s quasi-impossible for academics to study bond liquidity. I’d therefore never bothered to read the literature.
That was my loss!
So in my previous job I designed and implemented a market-making algorithm for government bonds based on the “skewed inventory” principle that people use in FX. My colleague Bernard and I had advertised our ability to do this to our employers, but in reality we did not crack the problem until we’d spent a good three months on it, often despairing we’d come up with something reasonable.
You can imagine my surprise when I saw the exact answer we came up with on page 150 of this book, which has been in print since 2013. I guess fixed income is a total backwater when it comes to formalizing how liquidity works. That’s my excuse, at any rate :-)
The book is split into three parts:
The first part is a survey of methods to calculate the right bid-ask for a trade. It starts simple and naïve and slowly builds in all the necessary components:
• a charge to compensate for some of the flow being, ahem, “informed”
• a charge (or rebate) for the fact that the trade will alter your inventory
• finally, drumroll please, your “rent”
The converse is covered too: How to go from observing the ticker tape to estimating what the market is charging for all of the above. I loved this part of the book, it made it worth the purchase.
The second part of the book covers “Market Design” and should be required reading for all regulators, commentators, for Michael Lewis wannabes etc. You find out that the dealers win if tick size is large, what volatility does to bid-ask (clue: it does not make it easy to quote), it explains what the “Flash Boys” do (with the best explanation ever of Regulation NMS) and generally speaking it’s “all you ever wanted to know about rent extraction but were afraid to ask.”
The third part of the book explores another very important aspect of liquidity: the fact that lack of liquidity can stand in the way of asset prices reaching their equilibrium. I’m close to Andrei Shleifer, but I’d never read the paper where he explains mathematically why “the market can stay irrational for longer than you can stay solvent.” The authors do a tremendous job of laying it all out, taking you through the logical steps of how arbitrageurs can be forced to liquidate good positions before the market does it for them. Bravo! They close the book by taking you through the latest theories regarding the impact of liquidity on corporate governance.
So what we have here is a potential five-star book, but it is marred by some schoolboy errors that will hopefully disappear from future editions. I’d forgive the authors if those mistakes had not cost me so much time to discover. I list them here to save you from scratching your head:
pp. 87-93 the authors confuse themselves for no reason. The spread in equation 3.12 can be derived trivially, but it needs to be imposed on the post-information mid, the one after we know if the customer wanted to buy or sell. So at the bottom of p. 93 where the authors say ASKt = MUt+ and BIDt = MUt- that’s plain wrong. You need to add the half-spread to MUt+ to get to ASKt and you need to subtract the half-spread from MUt- to get to BIDt.
p. 109 it’s wrong to say that Yt = Dt, it’s –Dt. But two wrongs make a right (think about it) and formula 3.45 a bit further down is correct.
p. 139 contrary to the claim the formulae do not describe the volatility in response to an uninformed trade. They describe the volatility in response to mixed flow of informed and uninformed trades.
Finally (and this is not really a mistake) on page 167 the author gets all the math right, but fails to draw a conclusion that could be super-helpful to arguments made in the second part of the book: the dealer rent may well wash out of the correlation, but it sure hurts the client’s back pocket!
Regardless of these mistakes, I thoroughly enjoyed this book and recommend it to anybody who wants to understand market liquidity. Don’t be scared, the math is totally within the grasp of a good high school student!
October 24, 2016
This book is only advised if you're into the inner workings of the markets. The book explains markets via various models, which can be a bit tedious. I've read this book for my master's course and it serves its purpose but i would not recommend it to anyone who just wants to learn the basics. Definitely not a bed-time book.
February 25, 2023
Typical textbook. Nothing too interesting.
Displaying 1 - 3 of 3 reviews