LO 52.2: Differentiate between exogenous and endogenous liquidity.

LO 52.2: Differentiate between exogenous and endogenous liquidity.
Exogenous liquidity refers to the bid-ask spread not being affected by the individual trades made by investors. This is more likely to be the case when the trades are relatively small. Endogenous liquidity refers to when a given trade can influence the liquidity risk of the trade (i.e., a trader submitting a buy or sell order that increases the spread). If an investor attempts to purchase a large block of an asset, for example, the buy order may have an impact on the spread and increase the cost over that indicated by the initial bid-ask prices. This can also happen when an investor tries to liquidate an asset. This type of endogeneity problem is more likely in illiquid markets and when the trade is large relative to the market.
In summary, for endogenous markets, if a trader attempts to liquidate (buy) a large position, the trader should expect the bid (ask) price to fall (increase) and the bid-ask spread to widen. The trader should include such a market reaction when estimating liquidity costs and risks. In both the endogenous and exogenous case, the bid-ask spread is still a function of the factors already mentioned (the number of traders, the standardization of the asset, low transactions costs, etc).
L i q u i d i t y -A d j u s t e d Va R

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