What statement best describes the influence of liquidity on asset prices?

What statement best describes the influence of liquidity on asset prices?

• A. Liquidity acts as a magnet for price
• B. Liquidity ensures prices do not move
• C. Liquidity fixes price errors permanently
• D. Liquidity is detrimental to price discovery

Answer: (C)

Liquidity shapes how quickly asset prices respond to new information. In a liquid market, trading can happen in large volumes with little price impact, so prices incorporate information rapidly. As mispricings arise, active trading and arbitrage push prices toward fair value, reducing price errors and making them less persistent. The idea that liquidity fixes price errors permanently captures this notion that liquidity supports quick correction and more accurate pricing, whereas the other statements misstate liquidity’s role: it does not prevent price movement, it does not act as a magnet for price, and it generally aids price discovery rather than harming it.

Liquidity shapes how quickly asset prices respond to new information. In a liquid market, trading can happen in large volumes with little price impact, so prices incorporate information rapidly. As mispricings arise, active trading and arbitrage push prices toward fair value, reducing price errors and making them less persistent. The idea that liquidity fixes price errors permanently captures this notion that liquidity supports quick correction and more accurate pricing, whereas the other statements misstate liquidity’s role: it does not prevent price movement, it does not act as a magnet for price, and it generally aids price discovery rather than harming it.