This book is about the pricing of liquidity. We present theory and evidenceon how liquidity affects securities prices, why liquidity varies over time,how a drop in liquidity leads to a decline in prices, and why liquiditycrises create liquidity spirals. The analysis has important implications fortraders, risk managers, central bankers, performance evaluation, economicpolicy, regulation of financial markets, management of liquidity crises, andacademic research.

Liquidity and its converse, illiquidity, are elusive concepts: You know itwhen you see it, but it is hard to define. A liquid security is characterizedby the ability to buy or sell large amounts of it at low cost. A good exampleis U.S. Treasury bills, which can be sold in blocks of $20 million dollarsinstantaneously at the cost of a fraction of a basis point. On the otherhand, trading an illiquid security is difficult, time-consuming, and/or costly.Illiquidity is observed when there is a large difference between the offeredsale price and the bid (buying) price, if trading of a large quantity of asecurity moves its price by a lot, or when it takes a long time to unload aposition. A recent example of this is collateralized debt obligations, whichinvestment banks have not been able to unload at an acceptable price for along time.