The Study Of Liquidity Of Stock Market

The most cursory observation of stock market teaches us that it does not lie within our power, when we have bought a stock for a certain price, to sell it again forthwith at the same price. The price at which any one can at pleasure buy a stock at a given point of time, and the price at which he can dispose of the same at pleasure, are two essentially different magnitudes. To narrow the spread of the two prices is one of the reasons why the organized stock exchange was established.Stock markets have two essential functions--liquidity and price discovery. It seems quaint that there are so many asset pricing models which have not concerned liquidity risk in classical capital market theory, while the real investors in stock market always worry about the illiquidity costs of their portfolio. Illiquidity can have large effects on asset returns, especially when investors face liquidity shocks and borrowing constraints.This paper distinguishes us from the usual viewpoints by the way we study the roles that liquidity plays in stock pricing, market microstructure, investor behaviors, and stock crashes. It studies market liquidity from the whole transaction process, not merely from market microstructure.The paper starts from the elusive concept of market liquidity by disassembling it into transaction cost, transaction volume and the waiting time before execution. It introduces, classifies and reviews the liquidity measures used in the analysis of security market and the fundamental characteristics, limits of application, and the relations among the liquidity measures.The paper studies empirically the effects of stock illiquidity on stock return, employing the transaction data from Shanghai Securities Exchange across 1997-"2002. The measures of stock illiquidity employed here are mainly price impacts ratios, and volume ratios. The results show that expected stock returns are an increasing function of expected illiquidity, which means that liquidity risk is one of most important factors when investors price the stock.The paper summaries the mechanism through which market microstructure affect market liquidity. It investigates how the trading mechanism, order types, information exposures, price controls, and other trading rules affect market liquidity separately. It also discusses thetradeoff of several market aims, among market liquidity, market efficiency, volatility and market transparency.The paper reviews investor rationale of classical capital market theory and the real investor's decision-making process in behavior finance. The behaviors of informed traders, noise traders, individual investors, institutional investors are all have close relations with market liquidity. The paper argues that all market microstructure characteristics are determined by the behavior of market participants. Plenty of investors who are different in volume, investor horizons, and risk aversion participate in the transactions of stock market to fulfill their trading demands, which results the liquidity of stock market. Classical capital market theory, which was based on the assumptions of symmetrical information and rational investors, can not explain the huge liquidity of real stock markets.The paper also concerns about stock crashes, by studying the effects of circuit breakers and investor behaviors during financial crisis. It is confirmed that market makers have a better performance than limit order traders in supplying liquidity and stabling the prices during stock crashes.The paper analyzes the rationale for, and profitability of, limit order trading because the profitability of limit order trading is essential to the viability of an order driven market just like Chinese stock market. Limit order traders gain from liquidity driven price changes but lose from information driven price changes. It is founded that some proprietary traders have an incentive to submit limit orders, that others prefer to submit market orders, and that this trading ecology can be self-sustaining, where public participants supply liquidity to thems...