Liquidity and Market Efficiency

46 Pages Posted: 4 Sep 2005

See all articles by Tarun Chordia

Tarun Chordia

Emory University - Department of Finance

Richard Roll

California Institute of Technology

Avanidhar Subrahmanyam

University of California, Los Angeles (UCLA) - Finance Area; Institute of Global Finance, UNSW Business School; Financial Research Network (FIRN)

Date Written: March 26, 2007

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.

Keywords: Market efficiency, liquidity, order imbalance

JEL Classification: G10, G14

Suggested Citation

Chordia, Tarun and Roll, Richard W. and Subrahmanyam, Avanidhar, Liquidity and Market Efficiency (March 26, 2007). Available at SSRN: https://ssrn.com/abstract=794264 or http://dx.doi.org/10.2139/ssrn.794264

Tarun Chordia

Emory University - Department of Finance ( email )

Atlanta, GA 30322-2710
United States
404-727-1620 (Phone)
404-727-5238 (Fax)

Richard W. Roll

California Institute of Technology ( email )

1200 East California Blvd
Mail Code: 228-77
Pasadena, CA 91125
United States
626-395-3890 (Phone)
310-836-3532 (Fax)

Avanidhar Subrahmanyam (Contact Author)

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-5355 (Phone)
310-206-5455 (Fax)

Institute of Global Finance, UNSW Business School

Sydney, NSW 2052
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

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