Measuring market liquidity: An introductory survey

TL;DR

This paper critically reviews various frameworks for defining and measuring market liquidity, emphasizing the importance of bid-ask spreads and intra-daily measures to capture market frictions and information flow.

Contribution

It provides a comprehensive survey of existing models and methods for assessing asset liquidity, highlighting the relevance of intra-daily data and bid-ask spread components.

Findings

Intra-daily measures effectively capture market liquidity dynamics.

Bid-ask spread components reflect different sources of market friction.

Market liquidity is closely linked to information arrival and transaction costs.

Abstract

Asset liquidity in modern financial markets is a key but elusive concept. A market is often said to be liquid when the prevailing structure of transactions provides a prompt and secure link between the demand and supply of assets, thus delivering low costs of transaction. Providing a rigorous and empirically relevant definition of market liquidity has, however, provided to be a difficult task. This paper provides a critical review of the frameworks currently available for modelling and estimating the market liquidity of assets. We consider definitions that stress the role of the bid-ask spread and the estimation of its components that arise from alternative sources of market friction. In this case, intra-daily measures of liquidity appear relevant for capturing the core features of a market, and for their ability to describe the arrival of new information to market participants.