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Equity Valuation and Portfolio Management by Harry M. Markowitz, Frank J. Fabozzi

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LIQUIDITY AND TRANSACTION COSTS

Liquidity is created by agents transacting in the financial markets when they buy and sell securities. Market makers and brokers–dealers do not create liquidity; they are intermediaries who facilitate trade execution and maintain an orderly market.

Liquidity and transaction costs are interrelated. A highly liquid market is one were large transactions can be immediately executed without incurring high transaction costs. In an indefinitely liquid market, traders would be able to perform very large transactions directly at the quoted bid-ask prices. In reality, particularly for larger orders, the market requires traders to pay more than the ask when buying, and to receive less than the bid when selling. As we discussed previously, this percentage degradation of the bid-ask prices experienced when executing trades is the market impact cost.

The market impact cost varies with transaction size: the larger the trade size the larger the impact cost. Impact costs are not constant in time, but vary throughout the day as traders change the limit orders that they have in the limit order book. A limit order is a conditional order; it is executed only if the limit price or a better price can be obtained. For example, a buy limit order of a security XYZ at $60 indicates that the assets may be purchased only at $60 or lower. Therefore, a limit order is very different from a market order, which is an unconditional order to execute at the current best price available ...

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