This paper develops a model for understanding liquidity via the pricing of limit orders. Limitorders can be well deÖned and priced with the tools of option pricing, allowing the complextradeo§ between transaction size and speed to be reduced to a single price. The option-basedframework allows the properties of liquidity to be characterized as functions of the fundamentalvalue and the order áow processes. In the special case when immediate execution is desired,the option strike price at which immediate exercise is optimal determines the e§ective bid/askprice. A model with full-information, but imperfect market making, is able to describe many ofthe known properties of transaction costs.
Source: 07-017.pdf