Measuring Market Liquidity

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Measuring Market Liquidity

• James P. Weston
• Jones Graduate School of Management

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Two basic areas in liquidity research

• Market Organization and Performance.
• How to estimate trading costs
• What are the best trading strategies?
• What market structure is best.
• The economics of information.
• How does real information get incorporated into
  the market price.

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Answers to these questions rely on

• Formal economic models of individual behavior
  (theory) that form testable hypotheses.
• Statistical time-series analysis of market
  behavior
• Institutional details that determine, limit, and
  influence markets.

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Answers to the big questions rely on liquidity

• Liquid markets
• Lower trading costs
• Faster trade execution
• More volume
• Information flows into the price quickly
• The best market is the most liquid market.

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What is liquidity?

• Ask a trader what they want from the market
  liquidity, liquidity, and liquidity
• Liquidity means different things to different
  groups
• Retail traders (care about costs)
• Institutions
• Dealers/Market Makers/Specialists
• Pacific Ocean vs. Kiddie Pool

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Measures of Market Liquidity

• Bid-Ask Spread
• Measures the cost of demanding immediacy.
• Market Depth
• Measures how thick the market is a particular
  price and time.
• Volume
• Measures how much trading activity there is
• None of these measure really get at the heart of
  liquidity.

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Price Impact of a Trade

• How do prices respond to trading?
• Not at all ? Pacific Ocean
• Very sensitive ? Kiddie Pool
• This is based on economic fundamentals (Kyle 1985)

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Why not just look at volume?

• Volume is closely related to volatility.
• Many studies show that volume and price
  volatility are closely related.
• For example surprise from the Fed!
• Volume skyrockets
• Volatility skyrockets
• Is this a more liquid market ?

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Price Impact of a Trade

• This is the measure professional traders care
  most about.

Price
Price Impact
Time
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The random walk model

• Price variations are driven by
• Permanent component (information)
• Transitory component (market-frictons)
• Lagged price adjustment
• Prices incorporate information (volume) and
  market frictions with some lag.

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A VAR model of price impact

• Vector autoregression analysis
• Easy to estimate and interpret.
• Rests on some very strong assumptions.
• Wold theorem
• a zero mean covariance stationary process can be
  written as a convergent vector moving average
  which (if it is invertible) has an AR
  representation ? this leads to a VAR specification

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A VAR model of price impact

• For example what is the impulse response on
  prices from a shock to volume?

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VAR representation (Hasbrouck 1995)
Is the estimated price impact
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Other time-series approaches

• What if the series is not invertible?
• If the time series are cointegrated one could
  proceed with an error-correction model (ECM)
  estimation.
• Nonlinearities?
• Prices may respond nonlinearly to trade size
  (kernel estimation, regime-switching)

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Other statistical wrinkles

• Deterministic Patterns
• Intraday patterns in volume, volatility, bid-ask
  spreads.
• Driven by market open/close, lunch-hour, etc.
• These features may bias our measurement of
  liquididty.
• Requires very careful treatment of seasonality.

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Example of Weird Seasonality

• Dollar Deutsmark Spot volume and volatility.

New York and London are open
Volume / Volatility
Japan opens
Japan Lunch hour
Greenwich mean time
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Weird Seasonality in Liquidity

• Model the seasonality flexible Fourier form
  (Anderson and Bollerslev 1998)

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Other statistical wrinkles

• Price discreteness and Clustering
• Price changes are bounded by the tick size.
• Bid-ask spreads induce spurious negative serial
  correlation in observed prices.
• Ordered-probit analysis.
• Markov-Chain-Monte-Carlo methods of getting the
  distribution right.

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Institutional details

• Prices and liquidity may be evolving in multiple
  markets.
• For example, the NYSE and the regional stock
  exchanges.
• Multiple market mechanisms
• Floor trading / dealer markets / Electronic
  markets.

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Measurement of Liquidity

• The definition and measurement of market
  liquidity is an active area of research.
• Can involve complicated time-series dynamics and
  some statistical heavy-lifting.
• It is also critical to understand the economics
  and financial market structure.
• As a result, the measurement of market liquidity
  offers a blend of statistics, finance, and
  economics well-suited to the development of CoFES.