The implications of liquidity and order flows for neoclassical finance

While liquidity and order flows are microstructure constructs, we show that they have profound implications for all of finance. In particular, liquidity is intimately connected with the fundamental building blocks of finance, namely, the pricing of risk, the powerful no-arbitrage theorems, and market efficiency. Large-sample studies of liquidity show that both liquidity and liquidity risk are priced in the cross-section of stock returns, the law of one price is more likely to hold in more liquid markets, and liquidity enhances market efficiency. Hence policies to enhance liquidity encourage efficiency and reduce costs of raising capital. Furthermore, order flows are powerful predictors of returns as well as the real economy.