The role of liquidity in financial markets

textIn the finance context, the term "liquidity" is usually associated either with "liquidity preference" or the "ease with which an asset can be bought or sold at minimum cost." This dissertation seeks to address three issues pertaining to these areas. First, we argue that the reason why investors have a liquidity preference in the fixed-income market is not to preserve liquidity but to minimize interest rate risk. Investors will not invest in long-maturity fixed-income securities unless they are compensated for the risk they take by investing in such securities. This leads to positive expected excess returns on long-maturity securities vis-a-vis short-maturity ones. Second, we examine long-maturity fixed-income securities to determine whether there exists a term premium which is monotonically increasing in the term to maturity of the security. Third, we consider liquidity in the context of the "bid-ask spread" and argue that the liquidity of a firm's equity securities will be a direct function of the financial condition of the firm, that is firms in poorer financial condition will have lower security liquidity. Our findings suggest that 1) there is indeed a positive relationship between risk and expected return in the fixed-income market, 2) there does exist a term premium in the fixed-income market which increases approximately monotonically with the term to maturity of the fixed-income instrument, and 3) the liquidity of a firm's equity is indeed a function of its financial condition.Financ