A new measure of liquidity

Abstract

We propose a new measure of market liquidity based on the investors’ optimal searching behaviour. Thus, we add a wealth filter on Pagano (1989)'s measure of liquidity to build the strong tie between endogenous market participation and investor wealth, as has been documented by empirical works.

Acknowledgements

We’re grateful to Wu Xiaoqiu, Wang Changyun and an anonymous referee of this journal for their comments and critics. All errors, however, are surely the authors’ responsibilities. This article's findings, interpretations and conclusions are entirely those of the authors and do not necessarily represent the views of FSI, its executive directors.

Notes

¹ Since there has already existed a lot of articles focusing on the effects of transaction costs or participation costs on market liquidity, where market structure itself and trading mechanism are their main concerns, we try to investigate the effects of investor structure on market liquidity. Thus our model has a new policy implication for some emerging markets: Introducing institutional investors (including foreign institutional investors) may improve market liquidity to some extent. Surely we could add some transaction costs in the second stage (optimal portfolio decision-making stage) of our model, but it is not our main concern here and it wouldn’t change our main conclusions as well.

² We model the second stage in a companion paper Wang and Wu, (2005) with our measure of liquidity.

³ The empirical method to calculate liquidity with this measure is discussed in Wu (2004) where he empirically tests the relationship between asset prices and market liquidity.