LO 65.2: Examine the relationship between market imperfections and illiquidity.

LO 65.2: Examine the relationship between market imperfections and illiquidity.
Many economic theories assume that markets are perfect. This means that market participants are rational and pursue utility maximization, that there are no transaction costs, regulation or taxes, that assets are perfectly divisible, that there is perfect competition in markets, and that all market participants receive information simultaneously. The reality, though, is that markets are imperfect.
Imperfections that encourage illiquidity include: Market participation costs. There are costs associated with entering markets, including
the time, money, and energy required to understand a new market. In many illiquid markets, only certain types of investors have the expertise, capital, and experience to participate. This is called a clientele effect. There will be less liquidity in markets that are suited to a limited number of investors and/or where there are barriers to entry in terms of required experience, capital, or expertise.
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Topic 65 Cross Reference to GARP Assigned Reading – Ang, Chapter 13
Transaction costs. Transaction costs include taxes and commissions. For many illiquid
assets, like private equity, there are additional costs, including costs associated with performing due diligence. Investors must pay attorneys, accountants, and investment bankers. These costs can impede investment.
When acknowledging the existence of transaction costs (i.e., acknowledging that markets are imperfect), some academic studies assume that as long as an investor can pay the transaction costs (and sometimes these costs are large), then any investor can transact (i.e., any asset can be liquid if one can pay the transaction cost). However, this is not always true. For example, there are: Difficulties finding a counterparty (i.e., search frictions). For example, it may be difficult to find someone to understand/purchase a complicated structured credit product. It may also be difficult to find buyers with sufficient capital to purchase an office tower or a skyscraper in a city like New York. No matter how high the transaction cost, it may take weeks, months, or years to transact in some situations.
Asymmetric information. Some investors have more information than others. If an
investor fears that the counterparty knows more than he does, he will be less willing to trade, which increasing illiquidity. When asymmetric information is extreme, people assume all products are lemons. Because no one wants to buy a lemon, markets break down. Often liquidity freezes are the result of asymmetric information. Because investors are looking for non-predatory counterparties who are not seeking to take advantage of asymmetric information, information itself can be a form of search friction.
Price impacts. Large trades can move markets, which, in turn, can result in liquidity
issues for the asset or asset class.
Funding constraints. Many illiquid assets are financed largely with debt. For example, even at the individual level, housing purchases are highly leveraged. As a result, if access to credit is compromised, investors cannot transact.
Il l iq u id As s e t Re t u r n Bia s e s