Liquidity Risk in Limit Order Book Markets

Mayston, Daniel (2006) Liquidity Risk in Limit Order Book Markets. PhD thesis, Universität zu Köln.

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Abstract

This thesis examines liquidity risk in electronic limit order book markets. The liquidity of a financial security characterizes the speed and ease with which any amount of the instrument can be purchased or sold. Liquidity risk constitutes the danger that the liquidation of an asset can be very costly because trades incur high market impacts in illiquid markets - in the extreme the asset cannot be traded at all. In this thesis I focus on three specific dimensions of liquidity risk. Firstly, I examine how quickly new liquidity flows back into the market once the limit order book has been cleared (resiliency). Secondly, I investigate the spill-over process of liquidity from one asset to another asset (commonality). Thirdly, I examine the pricing implications that liquidity characteristics have on the price of the asset. In all, I find that liquidity follows a strong replenishment process which ensures the inflow of new liquidity. Liquidity movements tend to be market-wide with a particularly strong correlation further from the spread. In addition, I find evidence that liquidity characteristics have an impact on returns. Liquidity risk is particularly important for investors who face uncertain cash demands, who time trades or who split large trade volumes. The findings in this thesis show that there is considerable variation in liquidity and that a thorough understanding of these dynamics can contribute significantly to investment performance.

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