Liquidity and Zero Net Supply Assets

26 01 2010

In basic asset markets, the marginal investors typically hold a long position in the basic assets due to the positive net supply. For such assets, an agent who is the seller of the asset is no longer concerned about the liquidity of the asset after the transaction, however, it is an agent who is marginal investor or buyer of asset who will be concerned about the liquidity of the asset once he closes the transaction. If the marginal investor expects an illiquidity of asset in the market, he would demand a compensation for the lack of immediacy she faces if she wishes to sell the asset. Therefore, in such markets the investors will demand a liquidity premium on those assets. Hence, cetris peribus, the more illiquid an asset, the higher would be its liquidity premium and its required rate of return, and consequently, the price will be lower. Empirically, evidences from equity and bond market show that stocks and bonds with lower liquidity have lower prices and command higher expected returns. This includes both the theoretical studies of Longstaff (1995a) and Longstaff (2001), various studies in equity markets, in treasury bond market by Amihud and Mendelson (1991), Longstaff (2004), and in Corporate bond market by De Jong and Driessen (2007) and Nashikkar et al. (2008).

Derivative assets are not similar to underlying assets such as stocks and bonds. Liquidity of derivative assets captures the easiness of offsetting the trade by the dealer. The liquidity of derivative therefore has importance for the dealer and bears an effect on its price. Generally, derivatives are in zero net supply, therefore, the marginal investors who are concerned about the liquidity can be either long the derivative assets or short the derivative assets. Suppose the marginal investor concerned about liquidity of the asset is long, she will require a “reduction” in price as a compensation for illiquidity, whereas, when the marginal investor concerned about liquidity of the asset is short, she will ask for an “increase” in price as a compensation. Therefore, for zero net supply assets, both the buyers and sellers would be concerned about the illiquidity and would push the prices in the opposite direction. In such a market, if the marginal investors concerned about liquidity are net long, the buyer-effect will dominate i.e., they will demand lower prices for illiquid assets. Whereas, if the marginal investors concerned about liquidity are net short, the seller-effect will dominate i.e., they will demand higher prices for illiquid assets.

One can conclude that in asset market with positive supply, the marginal investor concerned about liquidity will be buyer of the asset and therefore she will command the liquidity premium. However, in case of assets with zero net supply, it can be either seller or buyer who commands the liquidity premium depending upon whether the net-buyers or the net-sellers of the zero supply assets are concerned with liquidity of the assets.

For Interest Rate Options (Caps and Floors), Deuskar, Gupta and Subrahmanyam (2009) find that the “seller-effect” dominates in that market and therefore, the more the illiquid options, the higher the prices. For CDS market, Bongaerts, De Jong, and Driessen (2010) find the strong evidence for an expected liquidity premium earned by the credit protection seller and a small liquidity risk premium.

I will post more time and again on the topic …

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