Liquidity and Market Efficiency

Abstract:     
Market efficiency, the timely incorporation of information into prices, remains a central and controversial issue in finance. The short-horizon predictability of returns from past order flows is an inverse indicator of efficiency. We analyze this predictability for NYSE stocks that traded every day from 1993 through 2002. Mid-quote return predictability is diminished when bid-ask spreads are narrower. Such predictability has declined over time with the minimum tick size. Variance ratios of five-minute and daily returns suggest that prices were closer to random walk benchmarks during decimal regimes than during regimes with higher tick sizes (and wider spreads). These findings support the notion that liquidity stimulates arbitrage activity, which, in turn, enhances market efficiency. Further, as the tick size decreased, open-close/close-open return variance ratios increased, while return autocorrelations decreased. This suggests an increased incorporation of private information into prices during more liquid regimes.

Number of Pages in PDF File: 46

Keywords: Market efficiency, liquidity, order imbalance

JEL Classification: G10, G14

working papers series