The Multiple Dimensions of Liquidity

Abstract

We introduce a novel method to aggregate the different dimensions of liquidity (tightness, depth and resilience) into a single 'unified' market-wide liquidity index. We rely on twenty-four measures of market liquidity divided into eight groups. Each group either represents direct trading costs, which refer to the spread estimates (tightness), or indirect trading costs, which span the price impact estimates (depth and resilience). The weights assigned to the different groups are time-varying and depend on three components: the correlation between groups, the liquidity pressure conveyed through the measures in the group, and their conditional variance. Our liquidity index succeeds in tracking the most important historic episodes of financial stress. Moreover, it shows the expected macroeconomic and financial relationships mentioned in the literature, and has some predictive power for future growth rates. Finally, our methodology can gauge the individual importance of each liquidity group over time. Our results show that price impact measures receive higher weights during tranquil periods, while spread estimates play a prominent role during periods of financial distress.

Keywords: market liquidity, trading volume, transaction costs, price impact, effective spread, financial crises, signal-to-noise ratio

JEL Classification: G01, G12, G14, E44