Measuring Liquidity

Abstract

This chapter addresses liquidity measurement. Liquidity has several dimensions, such as trading costs, the depth available to customers placing large orders, speed of execution, protection against execution risk, and so on. It is of paramount importance to practitioners, since illiquidity affects portfolio returns. Illiquidity is often gauged by the cost of trading, which has both an explicit and an implicit component. Explicit costs include broker commissions, transaction taxes, platforms' trading fees, and clearing and settlement fees. Implicit trading costs are those arising from the illiquidity of the market. The most direct way to measure implicit trading costs is to look at market quotes and do a “what if” experiment: what would it cost to make a round-trip transaction, that is, to buy and instantly resell a given amount of securities? Different spread measures give different answers. Section 2.2 discusses the following spread measures: the quoted spread, the effective spread, and the realized spread. Section 2.3 presents additional measures of implicit trading costs: the volume-weighted average price; the estimated price impact of orders; measures of illiquidity based on non-trading; and Roll's measure of illiquidity, which is based on the serial covariance of transaction price changes. Section 2.4 considers the notion of implementation shortfall, a measure of execution quality that considers not only the price impact of orders but also the opportunity cost of delayed or partial execution. The final sections provide suggestions for further reading and exercises.