Does Liquidity Affect Securities Market Efficiency?

Abstract

I investigate the impact of liquidity on market efficiency using data from short-horizon binary outcome securities traded on an online exchange. I show that the most liquid securities markets exhibit significant pricing anomalies, such as overpricing low probability events and underpricing high probability events, whereas less liquid markets do not exhibit these anomalies. I also find that the prices of illiquid securities converge more quickly toward their terminal cash flows. These results are consistent with the idea that liquidity is a proxy for non-informational or noise trading, which can impede market efficiency; but they are inconsistent with models in which increases in liquidity have no impact or a favorable impact on efficiency.