A Unified Market Liquidity Measure

Abstract

We introduce a novel method (based on Illing et al. (2006) and popularized by Holló et al. (2012) through the CISS measure) to aggregate different groups of liquidity measures (percent-cost proxies, cost-per-volume proxies, etc.), in order to accommodate for the ‘different dimensions of liquidity’ (Amihud et al., 2005) through a single ‘unified’ market-wide aggregate liquidity metric. The weights for the multiple dimensions are time-varying and depend on three components: the correlation between groups, the pressure conveyed through the measure (threshold), and their conditional variance. We evaluate the performance of our market liquidity measure in various ways. Most importantly, our liquidity measure succeeds in tracking the most important historic episodes of financial stress and has a close relation with many crisis indicators. Moreover, our unified liquidity measure shows the expected macroeconomic and financial relationships mentioned in the literature, and even has some predictive power for future growth rates of traditional variables. Finally, our methodology allows to gauge the individual importance of each liquidity group over time. Our results unveil the spread and effective tick liquidity groups as the main protagonist during turbulent financial periods.

Keywords: Liquidity, Trading Volume, Transaction Costs, Pricing Impact, Effective Spread, Financial Crises, Macro-financial Linkages

JEL Classification: G01, G12, G14, E44