Handbooks of Research Methods and Applications series
Edited by Adrian R. Bell, Chris Brooks and Marcel Prokopczuk
The liquidity of a financial market is universally recognized as one of the most important, if not the most important, determinant of market quality. Liquidity affects the cost of trading in financial markets and is, therefore, an important determinant of the performance of asset portfolios. Liquidity is also a decisive factor in the competition between trading venues for investor order flow because it affects the decision of traders concerning where to trade. But its importance extends far beyond the realm of market microstructure. The liquidity of an asset has implications for its expected rate of return and, in turn, for the cost of capital (see e.g. Amihud and Mendelson, 1986; Pastor and Stambough, 2003; Acharya and Pedersen, 2005). Recent academic research has uncovered several channels through which liquidity and corporate financing decisions are interrelated. Also, market liquidity varies systematically with the business cycle (Naes et al., 2011). Given the importance of the concept, a large number of academic studies have tried to explain liquidity (i.e., liquidity is the dependent variable in these models) while an even larger number of studies have included liquidity as an explanatory variable. In both cases the researcher obviously needs a valid and reliable measure of liquidity. In the past decades a plethora of liquidity measures have been proposed.
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