The Liquidity Discount

Modern finance theory is based on the competitive market paradigm (see Duffie 1992, Jarrow and Turnbull 1996). The competitive market paradigm has two implicit assumptions. The first is that security markets are perfectly elastic—that is, traders act as price takers. Price takers believe that they can buy and sell as many shares of a security as they wish without changing the price. The second is that all market orders for purchase/sales have immediate execution. Both of these assumptions are approximations, not satisfied even in the most liquid markets. The absence of these conditions is sometimes labeled “liquidity risk.” Given the existence of liquidity risk, the price for one unit of a security (one round lot), called the “market” price, is different from the price received for larger purchases or sales. There is a “quantity” effect on price. The market price, therefore, can be significantly different from the liquidation price. The purpose of this paper is to quantify this difference, called the “liquidity discount.” Liquidity risk has been studied from two different perspectives in the market microstructure literature. The first perspective is that liquidity risk is due to asymmetric (private) information. Large purchases/sales reveal private information, which influences the price paid/received (see Glosten and Milgrom 1985 or Kyle 1985). Trading by informed individuals should reflect this inelastic demand. The transaction price (and the