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illiquidity - T h e C o s t o f I lliq u id ity Aswath...

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Aswath Damodaran 1 The Cost of Illiquidity Aswath Damodaran
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Aswath Damodaran 2 What is illiquidity? The simplest way to think about illiquidity is to consider it the cost of buyer’s remorse: it is the cost of reversing an asset trade almost instantaneously after you make the trade. Defined thus, all assets are illiquid. The difference is really a continuum, with some assets being more liquid than others. The notion that publicly traded firms are liquid and private businesses are not is too simplistic. Liquid, widely held stock in developed market Stock in traded company with small float Stock in lightly traded, OTC or emerging market stock Treasury bonds and bills Hiihgly rated corporate bonds Real assets Private business with control Private business without control Which is more illiquid? Most liquid Least liquid
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Aswath Damodaran 3 The Components of Trading Costs for an asset Brokerage Cost : This is the most explicit of the costs that any investor pays but it is by far the smallest component. Bid-Ask Spread : The spread between the price at which you can buy an asset (the dealer’s ask price) and the price at which you can sell the same asset at the same point in time (the dealer’s bid price). Price Impact : The price impact that an investor can create by trading on an asset, pushing the price up when buying the asset and pushing it down while selling. Opportunity Cost : There is the opportunity cost associated with waiting to trade. While being a patient trader may reduce the previous two components of trading cost, the waiting can cost profits both on trades that are made and in terms of trades that would have been profitable if made instantaneously but which became unprofitable as a result of the waiting.
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Aswath Damodaran 4 Why is there a bid-ask spread? In most markets, there is a dealer or market maker who sets the bid-ask spread, and there are three types of costs that the dealer faces that the spread is designed to cover. The first is the risk cost of holding inventory; the second is the cost of processing orders and the final cost is the cost of trading with more informed investors. The spread has to be large enough to cover these costs and yield a reasonable profit to the market maker on his or her investment in the profession.
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Aswath Damodaran 5 The Magnitude of the Spread
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Aswath Damodaran 6 More Evidence of Bid-Ask Spreads The spreads in U.S. government securities are much lower than the spreads on traded stocks in the United States. For instance, the typical bid-ask spread on a Treasury bill is less than 0.1% of the price. The spreads on corporate bonds tend to be larger than the spreads on government bonds, with safer (higher rated) and more liquid corporate bonds having lower spreads than riskier (lower rated) and less liquid corporate bonds.
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