In Search of the Best Proxy for Liquidity in Asset Pricing Studies on the Warsaw Stock Exchange

Abstract

Stock liquidity is unobservable, and thus, its level needs to be approximated. There is a large body of liquidity measures recorded in the existing literature. The main goal of this paper is to investigate which measure is the most appropriate one to measure stock liquidity for the purposes of asset pricing studies on the Warsaw Stock Exchange. To indicate the most appropriate proxy for liquidity, a series of correlation analysis between different liquidity measures and estimation error measures have been applied. Four high-frequency liquidity measures were used as a benchmark for liquidity, and fourteen low-frequency liquidity proxies were examined. The study was conducted on a group of 100 companies listed on the Warsaw Stock Exchange between 2006 and 2016. The ranking of low-frequency proxies for liquidity has been created based on eleven performance dimensions. It shows that the most appropriate liquidity measure on the Warsaw Stock Exchange is that developed by Fong et al. [12], which is a simplification of the zero-return-days measure developed by Lesmond et al. [20]. In addition, two modifications of Amihud’s [2] illiquidity are presented as the second and third best-performing ones. To the best of the author’s knowledge, this is the first such extensive study of the performance of liquidity measures on the Warsaw Stock Exchange. It examines both existing liquidity measures and some modifications proposed on the basis of the literature overview.