The Impact of Liquidity and Popularity on Asset Pricing

Anyone remember a TV show called “The Price is Right”? There, the contestants were called on stage to guess the price of regular household items, like a bottle of soap or a box of cereal. Those that picked the closest price advanced to the next round. If you ever watched the show attentively, you could not help but notice that the contestants priced more popular products more accurately. In other words, the more people used a product, the easier it was for its users to find the right price.

In Finance, such an approach also holds. The larger the number of traders, the faster they arrive at a consensus price. The process for the price formation is driven by supply and demand of various assets. The assets with more traders are known as “more liquid” assets. More liquid assets are known to incorporate information faster and represent more accurate prices than the assets neglected by traders.

However, in Finance, liquidity can be a self-fulfilling prophecy. Traders interested in liquid markets, say, market-making high-frequency traders, will gravitate to liquid markets already populated by other traders. Thus, liquid assets are likely to stay liquid or even become more liquid, while the illiquid assets may wither altogether. It’s like the value of the assets is tied to the popularity of the assets among the traders as well.

My latest research (with Dongwei Zhang of Cornell Financial Engineering) addresses this phenomenon head on. We show that not only popular assets stay popular, the prices on assets are also a function of their popularity with traders. Highly popular assets are more expensive relative to their underused colleagues.

This particular phenomenon is especially pronounced in cryptocurrencies, where the traditional valuation methodologies struggle. Unlike stocks, cryptos have no fundamental metrics like accounting variables to rely upon. Furthermore, we show that the relationship between crypto volume and prices is highly non-linear: when the trading volume increases a little, the prices increase by a dramatic leap.

I am working on a number of interesting applications in the space and will be happy to help your clients to make sense of it all. Please reach out for consulting opportunities+.

Irene Aldridge is an investment consultant and author of several books, including “Big Data Science in Finance” (with Marco Avellaneda, Wiley, 2021). She can be reached at irene@ablemarkets.com