Liquidity In Financial Markets

Liquidity is one of the key features of financial markets. Yet, little is known about its time-series dynamics and, especially, its drivers. Liquidity is defined as the extent to which a (financial) asset can be traded in the market, in a quick fashion and without affecting the asset's price (\cite{OH04}, \cite{CSS03}). The multidimensional character of liquidity makes it difficult to quantify and analyze its dynamics. Additionally, the high interdependencies with a broad range of firm-, market- and macroeconomic factors make liquidity an extremely complicated concept. \\

A better understanding of the time-series process of liquidity is not only of academic interest but can also be of great benefit in practice. Fund managers can improve trading strategies if they have a better understanding of liquidity dynamics (\cite{KKM15}). The effect of liquidity on trading costs directly influences required returns. The model of \cite{AM86} shows that higher-spread assets yield higher expected returns, also called the liquidity premium. However, since the 80s much has changed in the investment landscape. Technological changes have caused transaction costs of stocks to considerably decline and trading frequency

Market micro-structure models explain the occurrence of bid-ask spreads, a measure of liquidity, due to three main types of costs occurred by market makers: order-handling costs (e.g. \cite{R84}), inventory costs (e.g. \cite{S78}, \cite{HS81}, \cite{SS95}), and adverse selection costs (e.g. \cite{K85}, \cite{GM85}). Based upon these theoretical frameworks, several drivers of liquidity have been identified. Although results are not conclusive across papers, some agreement is reached on factors that are of influence. Roughly speaking, drivers can be split up into three categories: market variables, macroeconomic variables and firm specific