Measuring Liquidity

Abstract This chapter discusses the measurement of liquidity in security markets. It starts from the distinction between explicit and implicit trading costs, and focuses on how implicit trading costs can be measured, depending on availability of different data about the trading process. Section 2.2 presents various measures of the bid-ask spread that can be constructed using quote and transaction data (the quoted spread, the effective spread and the realized spread). Section 2.3 shows how to measure implicit trading costs when only transaction data are available, such as deviations of transaction prices from the volume-weighted average price (VWAP), non-trading measures based on no change in transaction prices, and Roll’s measure of the bid-ask spread. It also discusses measures of price impact, which require midprice and order imbalance data. All these measures, however, neglect the time dimension of implicit trading costs: if traders are willing to trickle their orders into the market gradually, they may get a better average price, at the risk of incomplete execution. Section 2.4 discusses the notion of implementation shortfall, a measure of execution quality that considers not only the price impact of orders but also the opportunity cost of delayed or partial execution.