An Index-Based Measure of Liquidity

47 Pages Posted: 10 Mar 2011 Last revised: 5 Jan 2016

See all articles by George Chacko

George Chacko

Santa Clara University

Sanjiv Ranjan Das

Santa Clara University - Leavey School of Business

Rong Fan

Gifford Fong Associates

Date Written: January 4, 2016

Abstract

The liquidity shocks of '08-'09 revealed that measures of liquidity risk being used in most financial institutions turned out to be woefully inadequate. The construction of long-short portfolios based on liquidity proxies introduces errors such as extraneous risk factors and hedging error. We develop a new measure for liquidity risk using exchange-traded funds (ETFs) that attempts to minimize this error. We form a theoretically-supported measure that is long ETFs and short the underlying components of that ETF, i.e., long and short a similar set of underlying securities with the same weights. Pricing discrepancies between the long and short positions are driven by liquidity differences between the ETF and its underlying components. Constructing theoretically supported liquidity risk factors in a number of markets, we undertake several tests to validate our new liquidity metric. The results show that our illiquidity measure is strongly related to other measures of illiquidity, explains bond index returns, and reveals a systematic illiquidity component across fixed-income markets.

Keywords: ETFs, liquidity, immediacy

JEL Classification: G10, G12

Suggested Citation

Chacko, George and Das, Sanjiv Ranjan and Fan, Rong, An Index-Based Measure of Liquidity (January 4, 2016). SCU Leavey School of Business Research Paper No. 11-10, Available at SSRN: https://ssrn.com/abstract=1782295 or http://dx.doi.org/10.2139/ssrn.1782295

George Chacko

Santa Clara University ( email )

500 El Camino Real
Santa Clara, CA 95053
United States

Sanjiv Ranjan Das (Contact Author)

Santa Clara University - Leavey School of Business ( email )

Department of Finance
316M Lucas Hall
Santa Clara, CA 95053
United States

HOME PAGE: http://srdas.github.io/

Rong Fan

Gifford Fong Associates ( email )

3658 Mt. Diablo Blvd.
Suite 200
Lafayette, CA 94549
United States
925-299-7800 (Phone)

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