Advertisement

Liquidity and Market Structure

Authors

  • SANFORD J. GROSSMAN,

  • MERTON H. MILLER

    Search for more papers by this author
    • Department of Economics, Princeton University, and Graduate School of Business, University of Chicago, respectively. This paper was presented at the Annual Meetings of the American Finance Association, December 29, 1987, in Chicago. Helpful comments on an earlier draft were received from Kenneth Cone, Kenneth French, T. Eric Kilcollin, Andrei Shleifer, Lester Telser, and Robert Vishny


ABSTRACT

Market liquidity is modeled as being determined by the demand and supply of immediacy. Exogenous liquidity events coupled with the risk of delayed trade create a demand for immediacy. Market makers supply immediacy by their continuous presence and willingness to bear risk during the time period between the arrival of final buyers and sellers. In the long run the number of market makers adjusts to equate the supply and demand for immediacy. This determines the equilibrium level of liquidity in the market. The lower is the autocorrelation in rates of return, the higher is the equilibrium level of liquidity.

Ancillary