The Price of Immediacy
Santa Clara University - Finance Department
Jakub W. Jurek
University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)
Harvard Business School - Finance Unit
HBS Finance Working Paper No. 07-017
This paper develops a new model of transaction costs, arising as the rents that a monopolistic market maker is able to extract from impatient investors. The mechanism for trade is a limit order, and immediacy is supplied when the limit order is executed. We show that limit orders are American options and their value represents the cost of transacting. The limit prices inducing immediate execution of the order are functionally equivalent to bid and ask prices, and can be solved for various transaction sizes to characterize the market maker's entire supply curve. We find considerable empirical support for the model's predictions in the cross-section of NYSE firms. The model produces unbiased, out-of-sample forecasts of abnormal returns for firms being added to the S&P 500 index.
Number of Pages in PDF File: 39
Keywords: Liquidity, transaction cost, limit order, American option, early exercise
JEL Classification: G12, G13
Date posted: October 3, 2006
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