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Liquidity Index
Barry A. Goss * Liquidity is the ability to trade a desired quantity of an asset at the market price. Liquidity has value: a given security with greater liquidity will have greater value than a less liquid, but otherwise identical security. The cost of liquidity is important because it is a major component of transaction costs. With recent increases in volatility in financial markets there have been wide variations in market liquidity, which have led to greatly increased uncertainty for investors in planning future transactions. In the interests of effective risk management and minimum transaction costs, therefore, it is essential that investors are fully informed about current costs of liquidity. It is desirable also that they have access to forecasts of future liquidity costs, and if possible, to instruments which facilitate minimization of those costs. This paper, which proposes the publication of a Liquidity Index, addresses these issues. It is anticipated that the Index will reduce uncertainty facing investors, and assist in the forecasting of future liquidity costs. This will facilitate planning of transactions, and hence lead to a reduction in transaction costs. Moreover, it is suggested that a logical extension of this argument is the development of a derivative instrument which would further facilitate management of liquidity risk. The proposal discusses the determinants of the bid-ask spread, a popular measure of the cost of liquidity, with attention given to trading volume and volatility, and information which can augment the bid-ask spread to address its inherent limitations. It is proposed that, in addition to the publication of a Liquidity Index for a group of selected securities, a suite of specialized sub-indices for individual securities markets, together with information about market depth, should be made available to subscribers. Benefits to sub-index subscribers include extended information on liquidity conditions for particular securities, further reducing uncertainty facing those investors. Benefits to the index sponsor will include reputational enhancement, following media and research citation, and generation of subscription income. It is anticipated that the Liquidity Index also will generate benefits to third party investors in the wider economy, in the form of spillover effects, through the reduction in uncertainty and improved public information about the state of liquidity in securities markets. This would imply that the relevant financial services would be under-produced and over–priced, and should be subsidized to produce a social optimum in resource allocation. Furthermore, improved public information about liquidity will likely enhance transparency in these markets, and hence reduce the regulatory burden of disclosure. *B.A. Goss is Director, Futures Markets Research Associates Pty Ltd. ABN 112 191 027 |