Trades, Quotes and the Cost of Capital

This paper studies the quote-to-trade (QT) ratio, and its relation with liquidity, price discovery and expected returns. Empirically, we find larger QT ratios in small or illiquid firms, yet large QT ratios are associated with low expected returns. The results are driven by quotes, not by trades. We propose a model of the QT ratio consistent with these facts. In equilibrium, market makers monitor the market faster (and thus increase the QT ratio) in difficult-to-understand stocks. They also monitor faster when their clients are less risk averse, which reduces mispricing and lowers expected returns.