Abstract
In the literature of asset pricing, this paper introduces a new method to estimate the cost-based market liquidity (CBML), that is, the bid-ask spread. The proposed model of spread proxy positively correlates with the examined low-frequency spread proxies for a larger dataset. The introduced approach provides potential implications in important aspects. Unlike in the Roll bid-ask spread model and the CHL bid-ask estimator, the CBML model consistently estimates market liquidity and trading cost for the entire dataset. Additionally, the CBML estimator steadily measures positive spreads, unlike in the CS bid-ask spread model. The construction of the proposed approach is not computationally intensive and can be considered for distinct studies at both market and firm levels.
Highlights
This paper provides new insights of estimating the cost-based market liquidity in financial markets
The results importantly revealed, that the cost-based market liquidity (CBML) model has statistically strong correlation with the model proposed by Roll ( ), but the relationship of the CBML model is seen statistically moderate with bid-ask spread models proposed by Corwin and Schultz ( ) and Abdi and Ranaldo ( )
This work constructs a new proxy of the cost-based market liquidity from daily high, low, and close prices
Summary
This paper provides new insights of estimating the cost-based market liquidity in financial markets. To construct the CBML estimator, the model considers distinct theoretical assumptions: (a) high prices and low prices are always initiated by buyers and sellers, respectively (Corwin & Schultz, ); (b) an informed trader, either from buyer-side or seller-side, is always present with equal probability in the market (Glosten & Milgrom, ); (c) a transaction discloses inventory holding cost that liquidity providers demand against the provision of price fluctuations (Amihud & Mendelson, ); and (d) liquidity providers would be compensated for the order processing cost at the time of trade (Roll, ). This model looks at past prices by a logic that providers of liquidity would be compensated in the following trading session against the price fluctuations and administration expenses This implies, the CBML estimator reflects cost-based market liquidity for two-consecutive single days.
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