Pricing Implications of Shared Variance in Liquidity Measures

35 Pages Posted: 7 Mar 2007

See all articles by Lorán Chollete

Lorán Chollete

UiS Business School

Randi Naes

Norwegian Ministry of Trade and Industry

Johannes Atle Skjeltorp

Central Bank of Norway

Date Written: August 4, 2006

Abstract

This paper constructs fundamental liquidity measures and investigates the pricing implications of shared variation in a large set of high frequency liquidity measures. Through a common factor analysis we estimate three orthogonal liquidity variables that statistically capture time series variation in market wide liquidity. We uncover three main results. First, we document that not one but two of the common liquidity factors are significantly related to cross-sectional differences in returns. Interestingly, the two factors are related to the time and quantity dimension of liquidity, not the price dimension. Second, and perhaps more striking, we discover substantial heterogeneity in the liquidity factors. In particular, order-based liquidity measures cannot explain return differences while trade-based liquidity measures can explain returns. This heterogeneity is borne out by asset pricing tests, which indicate substantial differences in the pricing of trade and order-based portfolios. Third, there is strong evidence of parameter instability in the pricing of liquidity.

Keywords: Market microstructure, Common factor, Asset pricing, Liquidity factor, high frequency liquidity

JEL Classification: G12; G14

Suggested Citation

Chollete, Loran and Naes, Randi and Skjeltorp, Johannes Atle, Pricing Implications of Shared Variance in Liquidity Measures (August 4, 2006). NHH Dept. of Finance & Management Science Discussion Paper No. 2006/9, Available at SSRN: https://ssrn.com/abstract=968615 or http://dx.doi.org/10.2139/ssrn.968615

Loran Chollete (Contact Author)

UiS Business School ( email )

PB 8002
Stavanger, 4036
Norway

Randi Naes

Norwegian Ministry of Trade and Industry ( email )

P.O. Box 8014 Dep
N-0030 Oslo
Norway
+47 22 24 04 34 (Phone)
+47 22 42 40 62 (Fax)

Johannes Atle Skjeltorp

Central Bank of Norway ( email )

P.O. Box 1179
Oslo, N-0107
Norway

HOME PAGE: http://www.norges-bank.no/research/skjeltorp/

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