Basics of market liquidity risk | Macrosynergy Research (2024)

Market liquidity measures the cost efficiency of trading. Liquidity risk refers to the probability that these costs surge when trading is required. Liquidity and liquidity risk are major factors in the long-term performance of trading strategies. The apparent inverse relation between liquidity and expected returns also offers obvious profit opportunities. There are various conceptual solutions for measuring market liquidity timely.

Sources at the end of the post

The below are excerpts from the papers and the book. Emphasis and cursive text have been added.

Defining market liquidity

“From a trader’s perspective, the definition of liquidity could be formulated in the form of an answer to the following question: What amount of money can one invest without moving the market?…Liquid markets should exhibit five characteristics: (i) tightness, which refers to low transaction cost; (ii) immediacy, which represents the high speed of order execution; (iii) depth, which refers to the existence of limit orders; (iv) breadth, meaning small market impact of large orders; and (v) resiliency, which means a flow of new orders to correct market imbalances.”
[Danyliv , Bland, and Nicholass, 2014]

“Liquid markets are generally perceived as desirable because of the multiple benefits they offer, including improved allocation and information efficiency…They…permit financial institutions to accept larger asset-liability mismatches, both regarding maturity and currency.”
[Sarr and Lybeck, 2002]

Defining market liquidity risk

“Illiquidity is observed when there is a large difference between the offered sale price and the bid (buying) price…Liquidity risk is the risk that a security will be more illiquid when its owner needs to sell it in the future, and a liquidity crisis is a time when many securities become highly illiquid at the same time. Some liquidity crises are dramatic: investors have a hard time selling the equities they want when prices fall as they submit their sale orders; market makers who are supposed to provide liquidity take their phones off the hook; or currency traders say it will take twenty days to trade out of large positions instead of the usual two days”.
[Amihud, Yakov, Haim Mendelson, and Lasse H. Pedersen, 2014]

“Liquidity crises arise as shocks are amplified manifold through liquidity spirals. It describes how liquidity dries up when its providers – dealers, proprietary traders, and hedge funds – run out of capital and need to reduce their positions. A crash in market prices imposes greater constraints on the traders’ resources (i.e., reduces their funding liquidity), and consequently traders are less able to provide liquidity to the market. As the ability to fund trading activity declines, so does market liquidity. This generates a vicious cycle that creates liquidity crises: a reduction in market liquidity pushes prices down and worsens the funding problems, which, in turn, reduces market liquidity and increases volatility as market conditions spiral downward.”
[Amihud, Yakov, Haim Mendelson, and Lasse H. Pedersen, 2014]

Why market liquidity matters

“Asset managers and ordinary investors care about liquidity, insofar as it affects the return on their investments, because illiquid securities cost more to buy and sell. Illiquidity, which is opposite to liquidity, eats into an investor’s return. Another important aspect of liquidity is its effect on a portfolio evaluation: portfolio liquidation, including illiquid assets, may reduce the value of a portfolio significantly. From another point of view, a positive relationship between expected stock returns and illiquidity levels has been found, which opens up new investment opportunities.”
[Danyliv , Bland, and Nicholass, 2014]

“Across securities, investors are willing to pay lower prices, or demand higher returns, for securities that are more costly to trade. This gives rise to a positive relation between securities’ trading costs and expected returns, or a negative relation between trading costs and prices (for any given cash flow that the security generates). As the liquidity of securities rises, so does their price.
A rise in market illiquidity, which means a greater cost of trading, makes forward-looking investors require higher future yields on their investments for any given cash flows generated by these investments because they expect the illiquidity to persist for a while…Therefore, the effect of market liquidity shocks on securities market prices introduces additional risk to market returns beyond the risk that is associated with shocks to expectations about future cash flows.”
[Amihud, Yakov, Haim Mendelson, and Lasse H. Pedersen, 2014]

“The authors examine the relationship between expected equity returns and the level as well as the volatility of trading activity, which is a proxy for liquidity. The results show a negative and strong cross-sectional relationship between stock returns and the variability of dollar trading volume and share turnover— after controlling for size, book-to-market ratio, momentum, and the level of dollar volume or share turnover… sample of NYSE and Amex common stocks from January 1966 to December 1995… The authors conclude that the cross-sectional expected stock returns are influenced by both the level and the variability in measures of trading activity.”
[Chordia, Subrahmanyam, and Anshuman, 2001]

How to measure market liquidity

“The following groups of liquidity measures which are widely used in theory and in practice…[i] Spread-related measures capture the cost of the transaction…[ii] Average daily volume (ADV) is widely used by practical traders to estimate how difficult is to trade a particular stock: the higher the ADV the more liquid the stock and the easier it is to execute large orders without moving the market…[iii] Price-based measures use variance of returns and test the resilience of markets to stock-related news.”
[Danyliv , Bland, and Nicholass, 2014]

“A common way to include market liquidity risk in a financial risk model (not necessarily a valuation model) is to adjust or “penalize” the measure by adding/subtracting one-half the bid-ask spread.”
[Harper]

Sources

Danyliv , Oleh, Bruce Bland, and Daniel Nicholass (2014) “Convenient liquidity measure for financial markets”, December 2014http://arxiv.org/pdf/1412.5072.pdf
Amihud, Yakov, Haim Mendelson, and Lasse H. Pedersen (2013), “Market Liquidity Asset Pricing, Risk, and Crises”, Cambridge, January 2013.http://www.cambridge.org/gb/academic/subjects/economics/finance/market-liquidity-asset-pricing-risk-and-crises#contentsTabAnchor
Harper, David, “Understanding Liquidity Risk”, on Investopendia.http://www.investopedia.com/articles/trading/11/understanding-liquidity-risk.asp
Sarr, Abdourhmane, and Tony Lybek, (2002), “Measuring liquidity in Financial Markets”, IMF Working Paper, December 2002.http://www.imf.org/external/pubs/ft/wp/2002/wp02232.pdf
Chordia, Tarun, Avanidhar Subrahmanyam, and V. Ravi Anshuman,(2001), “Trading Activity and Expected Stock Returns”, Journal of Financial Economics vol. 59, no. 1 (January 2001):3–32
public summary : http://www.cfapubs.org/doi/pdf/10.2469/dig.v31.n3.908