DP142 | Trading Volume and Asset Liquidity

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01/12/1986

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Abstract

The existence of a centralized market does not in itself guarantee that an asset can be readily liquidated at no loss: if the market is not deep enough, traders will experience adverse changes in the market price in response to their transactions. Market depth, however, is a function of the entry decisions of all potential traders. Each trader will therefore judge the absorptive capacity of the market on the basis of his conjectures about the behaviour of the others. This creates an externality, and as often happens in situations where externalities are at work, multiple (rational expectations) equilibria are possible. The nature of the equilibrium which results depends on the initial conjectures that each trader forms about the choices of the others. If conjectures are "pessimistic", for instance, a market may remain trapped at an inefficient equilibrium, characterized by low trading volume and low liquidity.