THE SOURCE OF LIQUIDITY
If all information had the same impact on all investors, there would be no liquidity.
When they received information, all investors would be executing the same
trade, trying to get the same price. However, investors are not homogeneous.
Some traders must trade and generate profits every day. Some are trading to
meet liabilities that will not be realized until years in the future. Some are highly
leveraged. Some are highly capitalized. In fact, the importance of information
can be considered largely dependent on the investment horizon of the investor.
Take a typical day trader who has an investment horizon of five minutes and
is currently long in the market. The average five-minute price change in 1992
was — .000284 percent, with a standard deviation of 0.05976 percent. If, for
technical reasons, a six standard deviation drop occurred for a five-minute
horizon, or .5 percent, our day trader could be wiped out if the fall continued.
However an institutional trader—a pension fund, for example—with a
weekly trading horizon, would probably consider that drop a buying opportunity
because weekly returns over the past ten years have averaged 0.22 percent
with a standard deviation 2.37 percent
In addition, the technical drop has
not changed the outlook of the weekly trader, who looks at either longer technical
or fundamental information.
Thus, the day trader's six-sigma event is a
0.15-sigma event to the weekly trader, or no big deal. The weekly trader steps
in, buys, and creates liquidity. This liquidity, in turn, stabilizes the market.
All of the investors trading in the market simultaneously have different investment
horizons. We can also say that the information that is important at
each investment horizon is different. Thus, the source of liquidity is investors
with different investment horizons, different information sets, and consequently,
different concepts of "fair price."