A Model of Stochastic Liquidity

Watanabe, Masahiro

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A Model of Stochastic Liquidity

Yale ICF Working Paper No. 03-18

EFA 2003 Glasgow Annual Conference Paper

54 Pages Posted: 6 Jun 2003 Last revised: 29 Jan 2014

See all articles by Masahiro Watanabe

Masahiro Watanabe

University of Alberta - School of Business; University of Alberta - Department of Finance and Statistical Analysis

Date Written: January 21, 2014

Abstract

This paper proposes a dynamic multi-security model in which liquidity reflects stochastic variation, persistence, and commonality of underlying information variance. Illiquidity, price-change variance, and trading volume all increase in the size of information. Using high frequency data, I perform structural estimation of the model by Bayesian Markov-Chain Monte-Carlo simulation, with the conditional volatility of underlying information modeled as stochastic volatility or realized volatility controlling for microstructure noise. I find that a Dow stock's liquidity decreases in the size of information about not only itself but also about other Dow stocks, demonstrating a significant cross-sectional effect of information on liquidity.

Keywords: Kyle model, liquidity, stochastic and realized volatility, Bayesian Markov-Chain Monte-Carlo (MCMC), GARCH, trading volume

JEL Classification: G12, G14

Suggested Citation: Suggested Citation

Watanabe, Masahiro, A Model of Stochastic Liquidity (January 21, 2014). Yale ICF Working Paper No. 03-18, EFA 2003 Glasgow Annual Conference Paper, Available at SSRN: https://ssrn.com/abstract=413983