Virtually all financial indices are constructed from transactions prices. For very liquid markets such as the New York Stock Exchange, in which assets trade every day, the weighted average price adequately captures daily market dynamics. But for less liquid markets, such as the bond market, the housing market and the art market, the average observed transaction price might not be as informative. In fact, even the construction of an intra-day index of the NYSE poses a challenge due to illiquidity.
Not all securities transact in each interval of time, and the structure of the market is such that limit orders as well as market orders affect estimates of the time-series of index returns. In short, price indices in virtually all asset markets are conditional upon liquidity it is simply the definition of the interval of observation that determines the magnitude of the estimation problem.
Sellers of all sorts rational or irrational, informed or uninformed set reservation prices. For purely common value goods, the reserve indicates the seller's assessment of the economic value of the property. For a share of stock, the reserve might represent an assessment of the net present value of the future sales price, plus the discounted dividend stream over the time until sale. As such, the bid and ask prices for stocks can reflect differing individual opinions about economic value. For private value goods, the seller reserve also reflects the personal satisfaction the agent gets from ownership and use.
For instance, certain things such as a lock of hair have sentimental value to the owner, but virtually no value to a potential buyer. Other goods, like paintings, are a combination of private and public valuation. While many artworks are purchased for investment, certain owners derive extraordinary pleasure from owning particular pieces, and might set a reserve higher than the going "price" for the painting. The same can be said for single-family houses. Much home improvement actually detracts from the resale value of the house, while enhancing the private value to the owner.
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Estimating Indices in the Presence of Seller Reservation Prices
