Market Liquidity: An Elusive Variable

Abstract

Equity prices depend on risk, expected return, and market liquidity. Market liquidity, however, is an elusive variable. Prevailing thinking relates primarily to revealed liquidity (e.g., posted orders). The authors propose the concept of latent liquidity to complement this definition and discuss liquidity in terms of its empirical assessment, dependence on market structure, and effect on asset pricing. Regarding regulatory policy concerning market structure, the objective should be to enhance market quality, which is tantamount to liquidity provision. This should lead to extended economic benefits because one thing is widely agreed on: All financial markets would benefit from being more liquid.

TOPICS: Portfolio theory, portfolio construction, equity portfolio management

Key Findings

• • The title itself says it: Liquidity is an elusive variable. It is hard to define, measure, and find.

• • A large and important component of liquidity is latent liquidity: orders that are not posted on a lit book. Consequently, it is not possible to quantify liquidity empirically.

• • Illiquidity leaves its footprints in the transaction record: accentuated intraday price volatility and return autocorrelation. These are affected by the structural design of a financial market and by market structure regulation.