Large investors and liquidity: a review of the literature
A growing share of financial assets are held by large institutional investors whose desired trades are large enough to move prices in markets. Because large investors’ trades have “price impact”, asset markets are not perfectly liquid from their perspective. This illiquidity is likely to influence their decisions of which assets to hold and which assets to trade, and may influence how assets are priced. These insights on illiquidity and large investors motivated Pritsker’s (2002) modelling of liquidity in a market with large investors. This article is a companion piece to Pritsker (2002) which reviews the literature on asset liquidity and on large investors and suggests ways in which these research areas can be combined.
The standard competitive asset pricing paradigm assumes that individual investors’ desired trades are sufficiently small that each investor can take prices as given and hence choose their asset holdings while ignoring the price impact of their trades. The price-taking assumption is reasonable when applied to the trades of most individual investors, but it is less tenable when applied to the trades of institutional investors. The observed behaviour of many institutional investors - breaking apart a large trade into several smaller trades, or building up or selling a position over days - suggests that their desired trades have price impact, and that large institutions account for price impact when selecting their trading strategy (Chan and Lakonishok (1995)). One notion of a perfectly liquid asset is an asset for which individuals can buy and sell all that they want at current prices. This notion of liquidity suggests that many markets are essentially perfectly liquid from the perspective of small investors since prices do not change much, if at all, in response to their desired trades. However, many markets are not perfectly liquid from the perspective of large investors. Because large investors are faced with imperfect market liquidity, the lack of liquidity may influence their investment decisions. For example, large investors who anticipate a potential future need to sell off assets quickly at some unexpected future date to meet cash flow obligations may desire holdings of relatively liquid assets in order to minimise the transaction costs associated with future forced sales. This desire for relatively liquid asset holdings should be reflected in equilibrium asset prices and returns. The above observations suggest that large investors and asset market liquidity are related topics, and that whether liquidity risk is priced by the market may depend on the trading behaviour of large investors. The purpose of this paper is to review the literature on asset market liquidity and on large investors, and then suggest directions of research which synthesise the two topics. Motivated by the notion that large investors and liquidity are related, Pritsker (2002) studies asset market liquidity in a setting where there are many large and small investors who trade multiple risky assets over a large but finite number of time periods. The analysis in Pritsker builds on other models of large investors. The most closely related research is DeMarzo and Urosevic (2000), Vayanos (2001) and Urosevic (2001). The basic underlying framework in DeMarzo and Urosevic and in Vayanos is nearly identical. Both consider the behaviour of a single large investor and many small investors when the investors
Board of Governors of the Federal Reserve System. The views expressed in this paper are those of the author but not necessarily those of the Board of Governors of the Federal Reserve System, or other members of its staff. Address correspondence to Matt Pritsker, The Federal Reserve Board, Mail Stop 91, Washington DC 20551. Matt may be reached by telephone on (202) 452-3534, fax (202) 452-3819, or by e-mail at...
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