Free Sample: Friction in Financial Markets paper example for writing essay

Friction in Financial Markets - Essay Example

Friction is a concept that has become the centre of increased academic examination over the last thirty years. Prior dismissal of its importance under the efficient-market hypothesis has been replaced with intrigue and interest in improving the activities that underpin the market mechanism. Academics the world over have delved into the domain of liquidity, cutting open the chaotic fabric of financial markets in search of a utopian low-cost market devoid of information asymmetries.

When markets are liquid and trading is cheap people are less fearful of losses, are more likely to buy and sell regularly and have a greater propensity to instil bullish sentiment. By opening our eyes to the existence of friction, we can overcome it, by passing legislation and ensuring the implementation of new procedures to ratify any existing market incoherence or failings. Tighter markets are more efficient and more desirable. By understanding friction, we can envelop it, and attempt to eradicate it. Defining the concept: Friction as a measure of liquidity

Friction is a measure of liquidity, which indicates how easy it is to buy or sell assets in financial markets. H. R. Stoll, a major investigator in the field who pioneered a comparative study of friction on the NASDAQ and NYSE, states that “friction in financial markets measures the difficulty with which an asset is traded”, i. e. how liquid it is. Many other attempts have been made to define the topic more rigorously, though difficulty has been found in ascertaining an all-encompassing definition of liquidity itself.

So much so were academics Lippman and McCall embroiled in hammering out a rudimentary statement on liquidity that they effectively used a classical economic definition of liquidity to define friction. In saying that “friction could be measured by how long it takes optimally to trade a given amount of an asset”, we are paraphrasing what Lippman and McCall refer to as the ‘casual response’ of economists who define liquidity as ” the length of time it takes to sell an asset (i. e. convert it into cash). ” (Lippman & McCall, 1986)

We can also interpret friction in the Demsetzian sense, “as the price concession needed for an immediate transaction” (Demsetz, 1968), or the “price of immediacy”. Viewing it as “the payment required by another trader, such as a dealer, to buy (or sell) the asset immediately and then dispose of (acquire) the asset according to the optimal policy” (Stoll 2000), we intertwine the concept once again with liquidity. Regardless, we can say that in frictionless, efficient, broad, and deep markets, assets are as liquid as they possibly can be, and likewise, illiquid stocks are subject to inherent or external frictions.

Friction and liquidity are virtually inseparable: frictions are barriers to liquidity. Measurement and Differentiation: What are the sources of friction? In the Demsetzian model, friction equates to the difference between what suppliers of immediacy, or market markers, are willing to pay for an asset and what the demanders of immediacy, active traders, are willing to accept for an asset if the trade is to take place immediately. Stoll’s models for the analysis of friction were developed under this framework.

Since “immediate sales are usually made at the bid price, and immediate purchases are made at the ask price, the spread between the bid and the ask is one measure of friction. ” (Stoll 2000) Primarily, we must contend with the sources of real friction, what Stoll terms “the real resources used up to accomplish trades. ” For Demsetz and others of his era, the spread exists because the suppliers of immediacy require payment for their services.

These services require the use of real economic resources, i. e. processing costs. There is also an inherent inventory risk assumed at a price. Furthermore, market power cannot be discounted: powerful dealers can increase spreads themselves. However, as stated by others like Kyle (1985), the spread can be viewed in an informational sense, as “the value of information lost to timelier or better informed traders”, or as “a measure of the redistribution of wealth from some traders to others.

” (Stoll, 2000) One theory that has stemmed from this informational approach to friction, put forward by writers such as Copeland and Galai (1983), argues that by posting quotes, market makers grant options to the rest of the market, so the spread is simply the cost of the option. It is the more widespread opinion that “market makers are aware that some investors could be trading on superior information and thus increase the spread in order to offset the losses incurred from trading with these informed traders. ” (J.Board et al, 2002)

In this sense, asymmetric information is a major component influencing the size of the bid-ask spread, which can be reduced by ensuring greater transparency. Whilst we can say that real frictions do not have a permanent impact on price level, as they are compensated for by trading gains earned from the bid-ask bounce, informational frictions do. 1 Therein lays the basis for Roll’s framework (1984) for evaluating trading friction. The sources of the spread can be distinguished by comparatively examining the short-term price changes in stocks with their spreads.

Other empirical measures of total friction, such as the quoted and effective half-spreads, are static. Stoll himself produced a new, more dynamic way of measuring real friction, the traded half-spread. 2 This enables us to approximate informational friction over the long-term. 3 Further reflection on liquidity and its effect on friction Of course, the primary sources of real friction are essentially the costs of liquidity in most markets due to the presence of intermediaries: order processing costs and inventory holding risk. When the volume of trading increases, though, the expected length of the inventory holding period decreases also.

(J. Board et al, 2002) Therefore greater liquidity has the effect of reducing trading friction. Equally, larger orders, being more difficult to accommodate, lead to greater inventory imbalances, and thus widen spreads, as suggested by the model of Amihud and Mendelson (1980). Other writers, such as Ho and Macris (1985), argue that greater market depth can lead to wider spreads because dealers’ fixed costs (including the opportunity costs of their time) rise, despite the fact that increased competition between dealers should dissipate market power.

Indeed, if we examine Copeland and Galai’s free-option hypothesis from a market-wide perspective, as J. Board et al argue, it seems that dealers are less willing to revise quotes so as to avoid writing free options, and this decrease in competition effectively leads to wider spreads. A lack of liquidity at the market opening can also lead to wider spreads. 4 Thus any study of friction is fundamentally linked to the notion of liquidity. Both go hand in hand, in that the more liquid an asset is, the lesser the friction inherent in the disposal process.

We should not underestimate the importance of friction therefore in deciding market policy, and its effect on asset pricing. What are the factors determining the liquidity of an asset? Illustrate some of the concepts affecting liquidity using quoted bid-ask spreads from different markets. “Time is the essence of liquidity; the more quickly an asset can be converted into cash at market value, the greater is liquidity” Herring R. J. , Innovations to enhance liquidity: implications for systematic risk, 1992