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I agree with your thesis/explanation, but housing isn't a good example. Housing experienced a genuine fundamental demand rise as a result of lower interest rates. It's boom bust has more to do with issues like regional unemployment in S.Ontario and USA rules that permit easy exit of out-of-the-money mortgages.

If a house were perfectly liquid, like money, the equilibrium price/rent ratio would be infinite, like money
What? I can rent money all I want. At a price to rent ratio ranging from around 4% if it was a really good mortgage locked in at the best possible time, to 28% on a credit card, or even more from some guy named Luigi. Or a payday loan place.

Phillip: yes, perhaps I was pushing it a bit with the housing example. My guess is that the decrease in liquidity of houses as an asset will cause some decrease in price, but I don't know how much. I don't think the positive feedback on housing alone could be strong enough to flip houses from one equilibrium to another. But houses as part of the whole spectrum of assets? Who knows.

alexcanuck: 5,000 $20 banknotes pay no interest to the owner. A $100,000 bond pays (say) 4% interest to the owner. A $100,000 condo pays (say) $5,000 annual rent (or 5% interest) to the owner. If I own 5,000 $20 banknotes and want to earn interest, I have to sell them and buy a $100,000 bond, or $100,000 condo. When you lend money you are buying a bond (you get an IOU in return, and a bond is just an IOU). As you go from holding money, to holding bonds, to holding a condo, your interest rate goes up, but your liquidity goes down.

I wonder about the difference in price between near futures and distant futures of the same commodity, and if the higher liquidity of near futures has some effect on price differentials between them. Arbitrage definitely keeps the prices of the two in line, though there are probably exceptions to this.

John: can you run that one by me more slowly? Do distant futures prices tend to be higher or lower than the actual price when the future arrives (on average)? And is this distant future "bias" is bigger than the near future bias? And do near futures contracts tend to have higher trading volume than distant futures contracts? Are these effects "big"?

Hi Nick - if you follow this link, you'll see CBOT corn futures. The front contract is the March 09 contract. It has 10 times the volume that the May 09 contract does. Once March expires May will become the front contract and become the most liquid contract. This volume pattern is pretty standard in futures markets.

The difference in price between near and far contracts is governed by carrying charges - interest rates, storage costs etc. Traders engage in various forms of arbitrage to keep these prices in line.

I was just wondering if any sort of liquidity premium could ever exist for the front contract, given the fact that traders have the means to abitrage this way.

[Edited to make the click-through link - SG]

I never expected the difference in volume would be that big! I don't understand why volume would be bigger in the nearest than in the more distant contract: it might be for some fundamental reason; or it might be just another double equilibrium like in the on-the-run/off-the-run case.

Look, until a couple of weeks ago, I had very little sense of the macroeconomic importance of liquidity. I knew of course that people demanded money (the most liquid of all assets) as a medium of exchange, and that it's not a good idea to buy a house with a swimming pool or any paint other than "speculator beige" if you might plan to move soon, but I thought it was a reasonable working assumption to ignore differences in volume and liquidity in most other financial assets. What I still don't understand is: why liquidity matters so much; why transactions volume is so high (why don't people just buy and hold?); are volume and bid/ask spreads and market depth (the whole curve of bid/ask spreads as you trade larger and larger quantities) and brokers' commissions the whole story?

If liquidity is important, and valuable, then arbitrage will only partially eliminate yield spreads across near and distant futures contracts; just as arbitrage does not (normally) eliminate the yield spread between zero-interest currency and positive interest T bills.

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