Which statement best describes how higher market liquidity affects trading costs?

Which statement best describes how higher market liquidity affects trading costs?

• A. It increases bid-ask spreads.
• B. It worsens price discovery.
• C. It increases trading costs.
• D. It lowers transaction costs through narrower bid-ask spreads and better execution.

Answer: (D)

Higher liquidity means there are more buyers and sellers in the market, so trades can be executed with less impact on price and at tighter bid-ask spreads. When the difference between what buyers are willing to pay and what sellers want is small, the cost of trading decreases because you can enter or exit positions with less price loss and you don’t have to move the price as much to get filled. That’s why higher liquidity lowers transaction costs through narrower spreads and better execution. The other ideas don’t fit: spreads tend to narrow, not widen, as liquidity improves, so costs don’t rise. Price discovery is typically enhanced with more liquidity, not worsened, since more participants continually reflect information in prices. And overall trading costs do not rise with more liquidity; they fall or stay the same due to easier execution and smaller market impact.

Higher liquidity means there are more buyers and sellers in the market, so trades can be executed with less impact on price and at tighter bid-ask spreads. When the difference between what buyers are willing to pay and what sellers want is small, the cost of trading decreases because you can enter or exit positions with less price loss and you don’t have to move the price as much to get filled. That’s why higher liquidity lowers transaction costs through narrower spreads and better execution.

The other ideas don’t fit: spreads tend to narrow, not widen, as liquidity improves, so costs don’t rise. Price discovery is typically enhanced with more liquidity, not worsened, since more participants continually reflect information in prices. And overall trading costs do not rise with more liquidity; they fall or stay the same due to easier execution and smaller market impact.