Online Guide to Investments and Insurance

A major issue in the literature on empirical market microstructure is the appropriate measure of liquidity. Microstructure theory suggests that the transitory cost plus the price impact of a trade is a good measure of an asset’s liquidity. Brennan and Subrahmanyam (1996) suggest using microstructure data to estimate these cost components, using the Glosten and Harris (1988) model. Sadka (2006) and Piqueira (2004) follow this approach and estimate the time series of monthly illiquidity for individual assets from quote and transaction data using the TAQ database for the period 1993–2001. These are probably the most accurate measures of time-varying individual asset liquidity available. Based on these estimates, Sadka (2006) shows that the price impact component, rather than the transitory cost component, is the priced liquidity risk factor.

The Amihud and Mendelson (1986) pricing model discussed in the previous section shows the sensitivity of asset prices to liquidity. In reality, liquidity is not a constant but fluctuates substantially over time. Previous article, which graphed the quoted and effective bid–ask spread over time, illustrates this point. Recent studies on equity market liquidity, such as Chordia, Roll and Subrahmanyam (2000, 2001) and Hasbrouck and Seppi (2001), show that there is commonality in liquidity, i.e. shocks to the liquidity of individual stocks contain a common component. Moreover, returns on stocks tend to be correlated with changes in market-wide liquidity.

These results warrant investigating liquidity as a priced risk factor. In this setup, it is not only the level of transaction costs that determines asset prices, but also the exposure of returns to fluctuations in market-wide liquidity. Indeed, recent literature has shown that the (systematic) risk associated with common liquidity fluctuations is priced in the cross-section of expected equity returns. Pioneering work in this area was done by Amihud (2002). Important recent papers in this growing literature include Acharya and Pedersen (2005), Pastor and Stambaugh (2003) and Sadka (2006), who all document the significance of liquidity risk for the expected returns on equities.

The core of this blog consists of models of price formation that emphasize the role of transaction costs in financial markets. This chapter discusses the relationship between transaction costs and asset prices. The crucial question is whether transaction costs affect the price of the financial assets. Clearly, transaction costs are a measure of the degree of liquidity, and accordingly the purpose of this chapter is to show how asset prices and liquidity can be related. In the first section we build on the seminal work of Amihud and Mendelson (1986) and discuss models that relate the price of a stock to the level of liquidity. In the second section, we discuss the relationship between expected returns and liquidity risk.

From the investor’s point of view, transaction costs reduce the return on investments, so rational investors will require a compensation for expected transaction costs. This affects the price an investor is willing to pay for an asset. As a result, in equilibrium, transaction costs lead to lower asset prices and therefore to higher expected returns gross of costs. Let’s start with a simple example. Suppose an investor buys a stock for $100 (ask price) and holds it for one year. Suppose that after a year the ask price is $104, and the bid price is $102 (hence, the bid–ask spread is $2). To liquidate his position, the investor sells the asset at the bid price i.e. at $102. The return on the asset (measured as the ask–ask price increase) is 4 per cent, but the investor’s realized return is only 2 per cent! This illustrates that there is a difference between the gross return (before transaction costs) and the net return (after these costs).

A clear-cut empirical implication of the inventory model is that in setting their prices dealers take their inventory levels into account. More precisely, when their holding of a risky asset increases, they offer liquidity at better prices so as to induce their customers to buy. The opposite applies when their inventory decreases. There is a vast empirical literature on this issue. Hasbrouck and Sofianos (1993) and Madhavan and Smidt (1993) show that inventory changes have an effect on prices, so that quote revisions are negatively related to the specialists’ trades. They also show that quoted prices induce mean reversion in inventory towards the target portfolio. What is ambiguous, however, is the time horizon of inventory mean reversion. Both Hasbrouck and Sofianos (1993) and Subrahmanyam (2008) find evidence that specialists react slowly to inventory shocks, so that inventories can be persistent for up to two months. This slow adjustment is not due to hedging with positions in other stocks since, as Naik and Yadav (2003) more recently showed using data from the London Stock Exchange, dealer firms’ quote changes are significantly related to changes in their ordinary inventories, not to changes in equivalent inventories in other stocks. Thus it remains a puzzle
why it takes so long for inventory effects to be manifested in financial market data.

Local vocational schools can be particularly helpful in the development and prototyping phase of the inventive process. There are vocational schools for virtually every trade imaginable, from electronics and computers to welding and automotive repair. Students work under the close supervision of their instructors. You can often get a prototype, or a particular part of a prototype, made by a vocational school for a fraction of the cost a regular shop would charge for the same work.

These schools can be a low cost source of help during the research and development phase of your invention. You will need to work closely with them and, of course, have them sign the contractor’s non-disclosure agreement beforehand.

Assuming the results are favorable, the report you receive at the conclusion of the project can be an important and compelling part of the eventual product presentation that you will prepare for either attracting apotential licensee or obtaining funding for your start up business.

You are undoubtedly saying to yourself, “This all sounds great, but what is the catch?” You are right. There is a catch. Class projects usually take an entire semester to complete. If you are in a hurry to get the results of a marketability study then you will have to pay for the quick results by hiring one of the legitimate professional firms that perform this service. If, on the other hand, you are trying to save every penny possible, it may be worth it to you to wait a semester for the results. It’s your call. Colleges and universities are not the only sources of free marketability studies. High schools all over the country are starting entrepreneurial programs for their students. Often these programs are willing and anxious to perform market studies, surveys and focus groups for new products.

Before you approach a college professor to ask him to take on your product as a class project you will need to clearly establish what it is you wish to learn. There are usually no set guidelines on what the students will and will not do as a part of the project. The clearer you can be with your objectives, the more valuable their research will be to you. It is common for their studies to include research on the cost of manufacturing your product, possible channels of distribution, competing products, market resistance, advertising or consumer education that would be required for the end users to see the value of your product, potential retail pricing, and surveys and focus groups to study market acceptance for your product. The students may even be able to locate manufacturers that might eventually be interested in licensing your product. They may also research the viability of building a business around your invention. If your product is selected as a class project you could receive thousands of dollars worth of research absolutely free!

Using your product as a class project is a serious commitment on the professor’s part. You will need to approach it in a businesslike manner and be prepared with a list of what you hope to gain from the project. If you go with unclear objectives the professor is not likely to take you or your project seriously.

Many inventors overlook free or nearly free resources that are right under their noses: nearby schools and universities. Schools have marketing and business departments and they are constantly on the lookout for projects in which to involve the students.

The marketing department of a nearby university can be an extremely valuable yet inexpensive resource for inventors on a shoestring budget. Professors often jump at the opportunity to involve the students in research for an actual product that is in development. Many times it becomes a semester assignment for the students to do a thorough market search and evaluation of the potential viability of a product. This often includes the students conducting visits to local stores, thorough internet searches and catalog searches. The work done by the students is often more thorough than the work done by the independent inventor simply because many students are involved in the project.

Do not assume that a thorough market search will replace a patent search. It will not. Many items are patented that never make it to the marketplace.

Most university and college libraries are also open to the public. You may, or may not, be allowed to check out books, but you certainly have the opportunity to look at their collection of books, magazines and journals and glean information from them while you are at the library. University libraries are often the repositories of technical journals and books that are not available through the public library system. If your invention is technical or has technical components, you may find the exact information you seek at your local university or college library.

Scattered across the country are approximately sixty Patent and Trademark Depository Libraries. Patent and Trademark Depository Libraries (PTDL’s) are housed within existing public, academic, state and research libraries. The librarians who work in the PTDL’s are specially trained by the United States Patent and Trademark Office and can help inventors perform patent and trademark searches using the printed Gazettes of issued patents as well as the latest computer programs and technology for patent and trademark searching. PTDL’s have all the listings for patents and trademarks that are found in the USPTO’s Virginia offices. There is no difference. This means that you can accomplish as thorough and complete a patent search at one of these PTDL’s as you can accomplish at the USPTO in Virginia.

If you choose to license your product, you can often find every major manufacturer of your category of invention in those directories. If, instead, you choose to manufacture your product yourself, these directories often list distributors and sales representatives who work in your sector of the market. Either direction you choose to go, the trade directories are an extremely valuable free resource of information in one neat, tidy location. They can literally save you hours or days of time spent attempting to locate your potential customer, a manufacturer who might be interested in licensing your invention.

With the advent of the Internet, the information you are able to access through your local library expanded  exponentially. Now, if a book on a particular subject is available at any library, it is available to you. You simply submit a request and the library will have the book sent to your local library for you to pick up. Inter-library loans are now quite common. Libraries now have large collections of “how-to” videos. Check it out! You may find instructions on how do the very things you need. For example, they may have videos that show you how to make plastic molds, or how to solder, etc.