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The Empirical Analysis of Liquidity

Foundations and Trends in Finance 8, No 4, 263-365, 2015

Kelley School of Business Research Paper No. 2014-09

102 Pages Posted: 28 Feb 2014 Last revised: 18 Sep 2017

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

Avanidhar Subrahmanyam

University of California, Los Angeles (UCLA) - Finance Area; Institute of Global Finance, UNSW Business School; Financial Research Network (FIRN)

Date Written: October 2, 2014

Abstract

We provide a synthesis of the empirical evidence on market liquidity. The liquidity measurement literature has established standard measures of liquidity that apply to broad categories of market microstructure data. Specialized measures of liquidity have been developed to deal with data limitations in specific markets, to provide proxies from daily data, and to assess institutional trading programs. The general 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, 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. High-frequency traders trade in both a passive, liquidity-supplying manner and an aggressive, liquidity-demanding manner. Their overall impact improves both liquidity and price efficiency, but concerns remain regarding occasional trading glitches, order anticipation strategies, and latency arbitrage at the expense of slow traders. 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, reduces the cost of governance via intervention, 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. There is evidence that firms influence their own liquidity through a broad range of corporate decisions including internal governance standards, equity issuance form and pricing, share repurchases, acquisition targets, and disclosure timeliness and quality. 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.

Keywords: liquidity, empirical, review, patterns, corporate finance, asset pricing

Suggested Citation

Holden, Craig W. and Jacobsen, Stacey E. and Subrahmanyam, Avanidhar, The Empirical Analysis of Liquidity (October 2, 2014). Foundations and Trends in Finance 8, No 4, 263-365, 2015; Kelley School of Business Research Paper No. 2014-09. Available at SSRN: https://ssrn.com/abstract=2402215 or http://dx.doi.org/10.2139/ssrn.2402215

Craig W. Holden (Contact Author)

Indiana University - Kelley School of Business - Department of Finance ( email )

Kelley School of Business
1309 E. 10th St.
Bloomington, IN 47405
United States
812-855-3383 (Phone)
812-855-5875 (Fax)

HOME PAGE: http://www.kelley.iu.edu/cholden

Stacey E. Jacobsen

Southern Methodist University (SMU) - Edwin L. Cox School of Business - Department of Finance ( email )

P.O. Box 750333
Dallas, TX 75275-0333
United States

Avanidhar Subrahmanyam

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-5355 (Phone)
310-206-5455 (Fax)

Institute of Global Finance, UNSW Business School

Sydney, NSW 2052
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

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