CFA Institute Journal Review February 2015 Volume 45 Issue 2
A Practical Approach to Liquidity Calculation (Digest Summary)
Journal of Trading
Studying various liquidity measures, the authors propose a new measure that allows the user to estimate the liquidity of different instruments, regardless of exchange or the currency in which they are traded.
The authors show that their new liquidity measure allows for instantaneous calculation of the liquidity of an instrument or a historical measurement over the day. The new measure calculates the intraday value of liquidity through a time-scaling approach.
How Did the Authors Conduct This Research?
To define liquidity, the authors answer the question, What amount of money is needed to create a daily single unit price fluctuation of the stock? They estimate the liquidity measure as the ratio of volume traded multiplied by the closing price divided by the price range from high to low, for the whole trading day, on a logarithmic scale.
The authors use the price at the end of the trading period because it is the most accurate valuation of the stock at the time. They use the traded volume for the day, assuming volume traded is a linear function of time. Price range is for the whole trading session. The authors also calculate instantaneous liquidity using order book data and average daily volume. The formulas thus derived can be used in the calculation of liquidity for portfolios of both stock instruments and exchange-traded funds (ETFs).
The new liquidity measure eliminates the currency value from calculations. It is possible to compare instruments on different international markets directly using the new liquidity measure. It is extremely easy to calculate because all of the information required can be obtained from a newspaper or a free website.
How Is This Research Useful to Practitioners?
A financial instrument’s liquidity is fundamental to many financial applications. Knowledge about an instrument’s liquidity is useful for processes from portfolio construction to market abuse detection systems. So, the liquidity measure of a financial instrument is of enormous interest to portfolio managers and regulators alike.
The authors define liquidity as the ratio of the product of yesterday’s volume and closing price to the high-to-low price range on a logarithmic scale. The liquidity measure is estimated by its instantaneous equivalent, which is calculated using the order book data and average daily volume. It is calculated for the whole trading session. The authors show that the instantaneous liquidity measure has components related to market breadth, market depth, market resilience, and immediacy. They calculate the liquidity of an ETF on a logarithmic scale using the liquidity of the basket of underlying instruments and the liquidity of the ETF as an instrument.
This liquidity measure allows the user to measure the liquidity of different instruments without regard for the currency or exchange.
The authors propose a practical way of measuring liquidity, which can be used to calculate an instantaneous value of liquidity as well as its historical measurement. Because a financial instrument’s liquidity is fundamental to trading strategies, portfolio construction, and fraud detection, further research would yield some interesting insights on the liquidity measure.