The Price of Immediacy

This paper models transaction costs as the rents that a monopolistic market maker extracts from impatient investors who trade via limit orders. We show that limit orders are American options. 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 added to the S&P 500 index. CAPITAL MARKET TRANSACTIONS essentially bundle a primary transaction for the underlying security with a secondary transaction for immediacy. From this perspective, the price of immediacy explains the wedge between transaction prices and fundamental value and therefore represents a cost of transacting. Despite widespread interest among investors and corporations alike, a useful characterization of transaction prices has been elusive. This paper addresses this challenge by developing a parsimonious model of the market for immediacy in capital market transactions that yields an analytically tractable quantity structure of immediacy prices. An inherent friction that limits liquidity in capital markets is the asynchronous arrival of buyers and sellers, each demanding relatively quick transactions. Grossman and Miller (1988) argue that the demand for immediacy in capital markets is both urgent and sustained, creating a role for an intermediary or market maker, who supplies immediacy by standing ready to transact when order imbalances arise (Demsetz (1968)).1 In this setting, the price of immediacy is determined by two factors: (1) the costs of market making and (2) the extent of competition among market makers. Many models assume perfect competition in market making. In this setting, the price of immediacy is determined as the marginal cost of supplying ∗Chacko is with 6S Capital AG, Santa Clara University, and Trinsum Group Inc.; Jurek is with Harvard University and Harvard Business School, and Stafford is with Harvard Business School. This paper has previously been circulated under the title, “Pricing Liquidity: The Quantity Structure of Immediacy Prices.” We thank John Campbell, Joshua Coval, Will Goetzmann, Robin Greenwood, Bob Merton, André Perold, David Scharfstein, Anna Scherbina, Halla Yang, and seminar participants at Harvard Business School, INSEAD, MIT, The Bank of Italy, and State Street Bank. We are especially grateful to an anonymous referee whose comments substantially improved the paper. 1 Empirical evidence on order submission strategies generally supports this view (e.g., Bacidore, Battalio, and Jennings (2003), Werner (2003), He, Odders-White, and Ready (2006)).