Pricing liquidity

This paper develops a model for understanding liquidity via the pricing of limit orders. Limit orders can be well defined and priced with the tools of option pricing, allowing the complex tradeoff between transaction size and speed to be reduced to a single price. The option-based framework allows the properties of liquidity to be characterized as functions of the fundamental value and the order flow processes. In the special case when immediate execution is desired, the option strike price at which immediate exercise is optimal determines the effective bid/ask price. A model with full-information, but imperfect market making, is able to describe many of the known properties of transaction costs.