The Empirical Analysis of Liquidity
Craig W. Holden
Indiana University - Kelley School of Business - Department of Finance
Stacey E. Jacobsen
Southern Methodist University (SMU) - Edwin L. Cox School of Business - Department of Finance
University of California, Los Angeles (UCLA) - Finance Area; Centre for International Finance and Regulation (CIFR)
February 26, 2014
We provide a synthesis of the empirical evidence on market liquidity. We begin with an overview of how liquidity is measured and specialized issues in liquidity measurement. The liquidity literature has established local cross-sectional patterns, global cross-sectional patterns and time-series patterns. Commonality in liquidity is prevalent. Certain exchange designs enhance market liquidity: a limit order book for high volume markets, a hybrid exchange for low volume markets, transparency of the limit order book, and multiple competing exchanges. Automatic execution increases speed, but increases spreads. A tick size reduction yields a large improvement in liquidity. Providing ex-post transparency to an otherwise opaque market dramatically improves liquidity. Opening up the limit order book improves liquidity. Regulatory reforms that increase the number of competitive alternatives, move towards linking them up, and level the playing field between exchanges improves liquidity. The liquidity and corporate finance literature provides abundant evidence that liquidity is beneficial in many corporate settings: liquidity increases the power of governance via exit, facilitates the entrance of informed traders who produce valuable information about the firm, enhances the effectiveness of equity-based compensation to managers, reduces the cost of equity financing, mitigates trading frictions investors encounter when trading in the market to recreate a preferred payout policy, and lowers the immediate transaction costs and subsequent liquidity costs for firms conducting large share repurchases. Further, the influence goes both ways as a broad range of corporate finance activities impact liquidity. The literature on liquidity and asset pricing demonstrates that both average liquidity cost and liquidity risk are priced, liquidity enhances market efficiency, and liquidity strengthens the arbitrage linkage between related markets. We conclude with directions for future research.
Number of Pages in PDF File: 77
Keywords: liquidity, empirical, review, patterns, corporate finance, asset pricingworking papers series
Date posted: February 28, 2014
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