Learning objectives: Define liquidity and describe the dimensions by which liquidity can be measured. Explain how liquidity is provided in different financial markets, including the role of market makers and the economics of market making.
Questions:
603.1. In PwC's Global Financial Markets Liquidity study (August 2015), the concept liquidity is given the following introduction and considered primarily along four dimensions: "Liquidity is a multi-dimensional concept, generally referring to the ability to execute large transactions with limited price impact, and tends to be associated with low transaction costs and immediacy in execution. While some market practitioners question whether liquidity can be adequately defined, we consider there are various aspects of liquidity that can be measured and studied. In particular we focus on the four attributes of: (i) immediacy; (ii) market depth and resilience, (iii) market breadth and (iv) tightness."
In regard to these four dimensions, each of the following is accurately defined EXCEPT which is false?
a. Resilience is the financial cost of completing a transaction; and it can be measured by exogenous price approaches including (most commonly) with bid-ask spreads
b. Immediacy is the time it takes to complete a transaction; and it can be measured by the average frequency of transactions or number of market makers and market participants
c. Breadth is the consistency with which liquidity is distributed within asset classes; and it can be measured by volume per segmented liquidity strata or the number/diversity of market participants
d. Depth is the frequency and flow of trading orders (deeper markets have greater flow) on both the buy and sell side; and it can be measured by endogenous price approaches; e.g., price elasticity of demand
603.2. In contrast to corporate hedgers (who seek to hedge specific business risks) or proprietary traders (who seek to maximize profits without a link to client services), market makers provide liquidity in a customer-driven business on a continuous basis. Consequently, the market maker faces an ongoing decision whether "to trade" or "to exit." In general and overall, this decision (by the market maker) depends on the trade-off between expected income and the risk that is warehoused by holding positions in the security. In specific, this decision depends on a number of factors.
With respect to each of these decision factors, each of the following tends to induce the market maker to exit (in other words, tends to induce the market maker to decide AGAINST trading in the market) EXCEPT which of the following tends to induce the market maker to trade?
a. Higher risk aversion
b. Higher variance of inventory value
c. Higher rate of transaction arrivals
d. Higher price elasticity of customer
603.3. Quantitative easing (QE) involves the purchases of financial assets financed by central bank increases in broad money holdings. According to PwC's study, "The US QE program was initiated by the Federal Reserve in November 2008 and in less than six months it had more than doubled its holdings of bank debt, US agency MBS and Treasury notes. QE2 and QE3 followed in November 2010 and September 2012, where the Federal Reserve implemented policies to purchase US$600 billion of Treasury securities and an open-ended US$40 billion per month programme to purchase agency MBS respectively. In November 2014 US QE came to an end, by which time US$4.5 trillion worth of assets had been purchased over a six year period. In the UK, the Bank of England initiated its £175 billion asset purchasing programme in March 2009. This increased to £200 billion in November 2009, and £275 billion in October 2011. The final asset purchases in February and July 2012 saw the total Bank of England purchases reach £375 billion. In response to deflationary risks in the Eurozone, the ECB initiated its own asset purchasing scheme in March 2015, where it committed to purchasing €850 billion of government bonds before September 2016."
About quantitative easing (QE), each of the following statements is true EXCEPT which is false?
a. Emerging markets have experienced increased capital flows as a result of quantitative easing in developed economies
b. Research studies conclude that although QE programs had no impact on equity prices or market liquidity, QE did increase market volatility and put sustained upward pressure on long-term interest rates
c. One of the primary transmission mechanisms of QE is portfolio re-balancing: unless money is a perfect substitute for the assets sold to the central bank, sellers may re-balance their portfolios by buying other assets
d. Two risks of QE are that it artificially compresses liquidity risk premia which could mask the impact of reduced market-making capacity, and importantly going forward, that the reversal of QE could lead to heightened illiquidity and volatility as markets adjust to a higher interest rate environment
Answers:
Questions:
603.1. In PwC's Global Financial Markets Liquidity study (August 2015), the concept liquidity is given the following introduction and considered primarily along four dimensions: "Liquidity is a multi-dimensional concept, generally referring to the ability to execute large transactions with limited price impact, and tends to be associated with low transaction costs and immediacy in execution. While some market practitioners question whether liquidity can be adequately defined, we consider there are various aspects of liquidity that can be measured and studied. In particular we focus on the four attributes of: (i) immediacy; (ii) market depth and resilience, (iii) market breadth and (iv) tightness."
In regard to these four dimensions, each of the following is accurately defined EXCEPT which is false?
a. Resilience is the financial cost of completing a transaction; and it can be measured by exogenous price approaches including (most commonly) with bid-ask spreads
b. Immediacy is the time it takes to complete a transaction; and it can be measured by the average frequency of transactions or number of market makers and market participants
c. Breadth is the consistency with which liquidity is distributed within asset classes; and it can be measured by volume per segmented liquidity strata or the number/diversity of market participants
d. Depth is the frequency and flow of trading orders (deeper markets have greater flow) on both the buy and sell side; and it can be measured by endogenous price approaches; e.g., price elasticity of demand
603.2. In contrast to corporate hedgers (who seek to hedge specific business risks) or proprietary traders (who seek to maximize profits without a link to client services), market makers provide liquidity in a customer-driven business on a continuous basis. Consequently, the market maker faces an ongoing decision whether "to trade" or "to exit." In general and overall, this decision (by the market maker) depends on the trade-off between expected income and the risk that is warehoused by holding positions in the security. In specific, this decision depends on a number of factors.
With respect to each of these decision factors, each of the following tends to induce the market maker to exit (in other words, tends to induce the market maker to decide AGAINST trading in the market) EXCEPT which of the following tends to induce the market maker to trade?
a. Higher risk aversion
b. Higher variance of inventory value
c. Higher rate of transaction arrivals
d. Higher price elasticity of customer
603.3. Quantitative easing (QE) involves the purchases of financial assets financed by central bank increases in broad money holdings. According to PwC's study, "The US QE program was initiated by the Federal Reserve in November 2008 and in less than six months it had more than doubled its holdings of bank debt, US agency MBS and Treasury notes. QE2 and QE3 followed in November 2010 and September 2012, where the Federal Reserve implemented policies to purchase US$600 billion of Treasury securities and an open-ended US$40 billion per month programme to purchase agency MBS respectively. In November 2014 US QE came to an end, by which time US$4.5 trillion worth of assets had been purchased over a six year period. In the UK, the Bank of England initiated its £175 billion asset purchasing programme in March 2009. This increased to £200 billion in November 2009, and £275 billion in October 2011. The final asset purchases in February and July 2012 saw the total Bank of England purchases reach £375 billion. In response to deflationary risks in the Eurozone, the ECB initiated its own asset purchasing scheme in March 2015, where it committed to purchasing €850 billion of government bonds before September 2016."
About quantitative easing (QE), each of the following statements is true EXCEPT which is false?
a. Emerging markets have experienced increased capital flows as a result of quantitative easing in developed economies
b. Research studies conclude that although QE programs had no impact on equity prices or market liquidity, QE did increase market volatility and put sustained upward pressure on long-term interest rates
c. One of the primary transmission mechanisms of QE is portfolio re-balancing: unless money is a perfect substitute for the assets sold to the central bank, sellers may re-balance their portfolios by buying other assets
d. Two risks of QE are that it artificially compresses liquidity risk premia which could mask the impact of reduced market-making capacity, and importantly going forward, that the reversal of QE could lead to heightened illiquidity and volatility as markets adjust to a higher interest rate environment
Answers:
