Econometric measures of liquidity

Abstract

A security is liquid to the extent that an investor can trade significant quantities of the security quickly, at or near the current market price, and bearing low transaction costs. As such, liquidity is a multidimensional concept. In this chapter, I review several widely used econometrics or statistics–based measures that researchers have developed to capture one or more dimensions of a security′s liquidity (i.e., limited dependent variable model (Lesmond, D. A. et al. Review of Financial Studies, 12(5), 1113–1141, 1999) and autocovariance of price changes (Roll, R., Journal of Finance, 39, 1127–1139, 1984). These alternative proxies have been designed to be estimated using either low–frequency or high–frequency data, so I discuss four liquidity proxies that are estimated using low–frequency data and two proxies that require high–frequency data. Low–frequency measures permit the study of liquidity over relatively long time horizons; however, they do not reflect actual trading processes. To overcome this limitation, high–frequency liquidity proxies are often used as benchmarks to determine the best low–frequency proxy. In this chapter, I find that estimates from the effective tick measure perform best among the four low–frequency measures tested.