The liquidity of an asset market refers to the ability of investors to buy and sell significant quantities of the asset, quickly, at low cost, and without a major price concession. A series of market crises that were associated with major decreases in liquidity, including the crash of 1987, the Asian crisis of 1998, and the credit crisis of 2008, have focused the attention of market participants, regulators and researchers on liquidity in financial markets.
A major question is whether investors demand higher returns from less liquid securities. Amihud and Mendelson (1986), Brennan and Subrahmanyam (1996), Brennan, Chordia, and Subrahmanyam (1998), Jones (2002), and Amihud (2002) all provide evidence that liquidity is an important determinant of expected returns. More recently, following the finding of commonality in liquidity by Chordia, Roll, and Subrahmanyam (2000), Pastor and Stambaugh (2003) and Acharya and Pedersen (2005) relate systematic liquidity risk to expected stock returns.
An important issue that arises in studies relating liquidity to asset prices and returns is the empirical proxy that is used for illiquidity. The simplest proxy is the bid-ask spread, which is the difference between the price effects of a zero size buy and a zero size sell. Other proxies relate the size of the trade to the size of the price movement (i.e., they measure the price impact of trades), while assuming that the price effects of buys and sells are symmetric. This price impact approach finds theoretical support in the classic Kyle (1985) model, which predicts a linear relation between the net order flow and the price change.
Amihud (2002) proposes the ratio of absolute return to dollar trading volume as a measure of illiquidity. In an alternative approach, Brennan and Subrahmanyam (1996) suggest measuring illiquidity by the relation between price changes and order flows, based on the analysis of Glosten and Harris (1988). Pastor and Stambaugh (2003) measure illiquidity by the extent to which returns reverse after high trading volume, an approach based on the notion that such a reversal captures the impact of price pressures due to demand for immediacy. Hasbrouck (2005) provides a comprehensive set of estimates of these and other measures of illiquidity, including the Roll (1984) measure.
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Sell-Order Liquidity and the Cross-Section of Expected Stock Returns
