Review Literature on Liquidity
Large investors and liquidity: a review of the literature
Matthew Pritsker
1
Abstract
A growing share of financial assets are held by large institutional investors whose desired trades are large enough to move prices in markets. Because large investors’ trades have “price impact”, asset markets are not perfectly liquid from their perspective. This illiquidity is likely to influence their decisions of which assets to hold and which assets to trade, and may influence how assets are priced. These insights on illiquidity and large investors motivated Pritsker’s (2002) modelling of liquidity in a market with large investors. This article is a companion piece to Pritsker (2002) which reviews the literature on asset liquidity and on large investors and suggests ways in which these research areas can be combined.
1.
Introduction
The standard competitive asset pricing paradigm assumes that individual investors’ desired trades are sufficiently small that each investor can take prices as given and hence choose their asset holdings while ignoring the price impact of their trades. The price-taking assumption is reasonable when applied to the trades of most individual investors, but it is less tenable when applied to the trades of institutional investors. The observed behaviour of many institutional investors - breaking apart a large trade into several smaller trades, or building up or selling a position over days - suggests that their desired trades have price impact, and that large institutions account for price impact when selecting their trading strategy (Chan and Lakonishok (1995)). One notion of a perfectly liquid asset is an asset for which individuals can buy and sell all that they want at current prices. This notion of liquidity suggests that many markets are essentially perfectly liquid from the perspective of small investors since prices do not change much, if at all, in response to their desired trades. However, many markets are not perfectly liquid
Matthew Pritsker
1
Abstract
A growing share of financial assets are held by large institutional investors whose desired trades are large enough to move prices in markets. Because large investors’ trades have “price impact”, asset markets are not perfectly liquid from their perspective. This illiquidity is likely to influence their decisions of which assets to hold and which assets to trade, and may influence how assets are priced. These insights on illiquidity and large investors motivated Pritsker’s (2002) modelling of liquidity in a market with large investors. This article is a companion piece to Pritsker (2002) which reviews the literature on asset liquidity and on large investors and suggests ways in which these research areas can be combined.
1.
Introduction
The standard competitive asset pricing paradigm assumes that individual investors’ desired trades are sufficiently small that each investor can take prices as given and hence choose their asset holdings while ignoring the price impact of their trades. The price-taking assumption is reasonable when applied to the trades of most individual investors, but it is less tenable when applied to the trades of institutional investors. The observed behaviour of many institutional investors - breaking apart a large trade into several smaller trades, or building up or selling a position over days - suggests that their desired trades have price impact, and that large institutions account for price impact when selecting their trading strategy (Chan and Lakonishok (1995)). One notion of a perfectly liquid asset is an asset for which individuals can buy and sell all that they want at current prices. This notion of liquidity suggests that many markets are essentially perfectly liquid from the perspective of small investors since prices do not change much, if at all, in response to their desired trades. However, many markets are not perfectly liquid
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