If market resiliency, a measure of liquidity, is the amount of time it takes a market to bounce back from temporarily incorrect prices, then what makes a price "incorrect"? Is this like fat-finger trades and flash crashes ?
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asked Oct 18, 2015 at 20:15
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2$\begingroup$ It doesn't have to be a "fat finger", any large trade will have a market impact (roughly proportional to the size of the trade) and then a return to the "intrinsic" or equilibrium price. $\endgroup$– Alex CCommented Oct 18, 2015 at 20:53
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1$\begingroup$ @AfterWorkGuinness I suggest you be more careful with the word "incorrect"... Perhaps "abnormal movements" or something similar would be more appropriate... $\endgroup$– Sergey BushmanovCommented Oct 18, 2015 at 22:30
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$\begingroup$ I borrowed the word from an article on Investopedia. "resiliency refers to the market's ability to bounce back from temporarily incorrect prices" which led to my question. I didn't realize incorrect = abnormal. $\endgroup$– AfterWorkGuinnessCommented Oct 18, 2015 at 23:01
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2 Answers
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Genereally speaking main identifed liquidity costs (or prices distortion - see Amihud, Y., Mendelson, H., Heje Pedersen, L., 2005. Liquidity and Asset Prices) are related to the asymmetric information theory, the inventory risk paradigm for market makers, trading costs and search problems. All that topics are studied in the Market Microstructure theory. A good starting point to know more about it is the following article : Madhavan, A., 2000. Market microstructure: A survey. Journal of Financial Market.
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In addition to Malick's paper, I believe Shleifer and Summers (1990), The Noise Trader Approach to Finance should answer your question. Some market participants are not fully 'rational' and their decisions to take or provide liquidity are not driven by fundamental pricing information, leading to 'inefficient' or 'irrational' prices.
This irrationality can be attributed to a variety of reasons - political (e.g. currency pegs), asymmetric information (traders acting on stale data), non-uniform trading costs etc.
The idea that liquidity is limited and therefore can be distorted by noise traders isn't something new, as reflected by Keynes's often-cited statement: "The market can stay irrational longer than you can stay solvent."
