Measuring and Modelling the Market Liquidity of Stocks: Methods and Issues

The liquidity of an asset in modern financial markets is a key and, yet, elusive concept. A market is often said to be liquid when the prevailing structure of transactions provides a prompt and secure link between the demand and supply of assets, thus delivering low costs of transaction. Providing a rigorous and empirically relevant definition of market liquidity has, however, provided to be a difficult task. This paper provides a critical review of the frameworks currently available for modelling and estimating the market liquidity of stocks. We discuss definitions of market liquidity that stress the role of the bid-ask spread and the estimation of its components arising from alternative sources of market friction. In this case, measures of liquidity based on intra-daily data are relevant for capturing the core features of a market, and for their ability to account for the arrival of new information.