The Price of Immediacy

39 Pages Posted: 3 Oct 2006  

George Chacko

Santa Clara University - Finance Department

Jakub W. Jurek

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Erik Stafford

Harvard Business School - Finance Unit

Date Written: March 2007

Abstract

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.

Keywords: Liquidity, transaction cost, limit order, American option, early exercise

JEL Classification: G12, G13

Suggested Citation

Chacko, George and Jurek, Jakub W. and Stafford, Erik, The Price of Immediacy (March 2007). HBS Finance Working Paper No. 07-017. Available at SSRN: https://ssrn.com/abstract=1001762 or http://dx.doi.org/10.2139/ssrn.1001762

George Chacko

Santa Clara University - Finance Department ( email )

Santa Clara, CA 95053
United States

Jakub W. Jurek

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-1588 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Erik Stafford (Contact Author)

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
617-495-8064 (Phone)
617-496-7357 (Fax)

Paper statistics

Downloads
708
Rank
27,377
Abstract Views
2,995