Liquidity Cost

[Jaskarn]

Hi @David Harper CFA FRM,

Hope you are doing great!!!

Dowd Chapter 14: Estimating Liquidity Risks

I wanted to understand about how we compute liquidity cost? Why we divide spread by half by saying we assume we are not buying and selling at the same time, I mean what does that mean?

What I understand is if
Bid=$10
Ask=$20
then it means that exchange will buy the particular commodity from us at 10 and the same commodity if we buy from exchange within a fraction of seconds they will sell us at 20. So, we are loosing $10 on this transaction and that is due to liquidity cost. But by dividing this spread of 10 by 2 what are we trying to say?

Thanks a lot for your time.

 

[Nicole Seaman]

Hi @David Harper CFA FRM,

Hope you are doing great!!!

Dowd Chapter 14: Estimating Liquidity Risks

I wanted to understand about how we compute liquidity cost? Why we divide spread by half by saying we assume we are not buying and selling at the same time, I mean what does that mean?

What I understand is if
Bid=$10
Ask=$20
then it means that exchange will buy the particular commodity from us at 10 and the same commodity if we buy from exchange within a fraction of seconds they will sell us at 20. So, we are loosing $10 on this transaction and that is due to liquidity cost. But by dividing this spread of 10 by 2 what are we trying to say?

Thanks a lot for your time.

@Jaskarn

I just wanted to see if you had tried using the search or tag function to find the answer to your question. There are MANY threads in the forum that discuss liquidity risk and cost, especially pertaining to the Dowd reading. You can use the search function to search for "liquidity cost" or "liquidity risk" and many threads will come up. We also have a "liquidity-risk" tag that will bring up many other threads. As we get closer to the exam, we just need to make sure that everyone is trying to search for their answer before posting a new thread, as David's time gets very thin as the May exam approaches and it is important that he isn't having to repeat himself if the concept has already been discussed elsewhere.

If your doubts are about a specific practice question, it is also helpful if you post the actual question so we know what you are referencing.

Thank you

Nicole

 

[David Harper CFA FRM]

Hi @Jaskarn Thank you, I'm doing okay .. ready for a couple days off, truth be told (which will have to wait until next weekend!). Yes, I believe you are correct, that the raw bid-ask spread (in your example $10.00) is the total cost of a purchase-then-sale which is two transactions.

But liquidity risk concerns not the "round-trip" of a purchase then sale, but the "one-way trip" of an already-owned position sold. So the idea is that you are incurring only half of this total cost in the sale.

Another way to look at this is: when you own the asset, presumably it's price is the mid-market price: the average of the ask and bid. The spread = [P(ask) - P(bid)]/P(mid) such that one-half the spread is the cost to sell as measured by the difference between the exit price (i.e., the bid to the customer of the market maker) and the mid-market price. I hope that's helpful!