Market Efficiency and Liquidity

The main theme of this thesis is to investigate the interaction between market efficiency and liquidity. In particular to document time- and cross-sectional variation in market efficiency, and whether individual stock efficiency co-moves with aggregate market efficiency; to investigate why inefficiencies arise and how trading against these inefficiencies affects market liquidity. Theory predicts that arbitrage improves financial market liquidity when arbitrage opportunities arise as a result of temporary demand shocks and worsens liquidity when arbitrage opportunities arise as a result of differences in information. My analysis suggests that around 70% of the arbitrage opportunities arise as a result of demand shocks. Consistent with theory, I then show that an increase in arbitrage activity is associated with a reduction in market order imbalance and an improvement in liquidity.