Research Summary
Research Summary
Discontinuous Trading: A Poisson Model of Liquidity Pools (May 2005)
Description
Abstract: Liquidity can be defined as the ability to trade instantaneously at fundamental value. When opportunities to trade at fundamental value are the exception, not the rule, investors may in practice trade only during these short-lived liquidity pools. To capture this effect, I make the simplifying assumption that trading opportunities arrive randomly by a Poisson process. I then derive an approximation for the value function of an investor with power utility over consumption and an infinite horizon. I find that the welfare effects of illiquidity are potentially significant for assets with expected time-between-trades of 100 days, but much less significant for assets traded every 10 days. Thus, trading on the order of every 10 days can be considered to be ``close'' to continuous time.