Global Evidence on the Premium for Market Illiquidity

Amihud, Yakov;Hameed, Allaudeen;Zhang, Huiping

Abstract

[Extract] Market liquidity is a primary concern for investors as it affects their ability to get into and out of their security investments at minimum costs. Liquidity refers to the ease at which assets can be traded without significantly moving its price. In a frictionless capital market, there is no role for liquidity as investors can buy or sell assets in any quantity without incurring costs. However, in reality, there are trading costs associated with buying and selling securities. An important component of the trading costs is the price impact of trades. A security is illiquid if the seller who initiates the trade has to sell at a discount from prevailing prices2 to be able to execute the sale immediately. Similarly, a buyer who initiates the trade of an illiquid security may have to pay a premium to induce investors to sell to her quickly. Hence, the price impact of trading reflects the liquidity of the underlying asset and market. The bid and ask quoted prices can be viewed as the price impact of a sell and a buy transaction, respectively, for standard market orders that do not exceed the quoted depth at these prices, that is, the quantities for which these quotes apply. Amihud and Mendelson (1986) propose that illiquidity is priced, that is, illiquid stocks—those with greater trading costs—command a higher expected return relative to liquid ones in equilibrium, since investors demand higher compensation for bearing illiquidity costs.

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Macroeconomic Review

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Macroeconomic Review

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0219-8908

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Monetary Authority of Singapore

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