Proper Liquidity Measures

Abstract

Liquidity is easily perceived but not easily defined in financial markets. In this study, we present a class of liquidity measures called Proper Liquidity Measures (PLM). We prove that widely used measure such as percent quoted spreads and the Amihud measure fulfill our axioms. PLMs can be composed from the ratio of Generalized Deviation Measures to Negotiability Variables. We analyze specific measures and propose PLMs on the basis of semi-deviations. Two empirical exercises test the performance of these measures: a) the relationship between liquidity and implied volatility and b) common factors in liquidity and tail risk. Applications provide both support for the use of PLM and new insights on liquidity.

Keywords: Generalized Deviation Measure, Liquidity, Implied Volatility, Tail Risk

JEL Classification: C65, G12, G32