Associate Professor, Nanyang Technological University
DAVID K. DING
Professor, Massey University and Singapore Management University
YUNG CHIANG YANG
Assistant Professor, Queen's University Belfast
No agreement exists on a single definition of liquidity. Kyle (1985, p. 1316) notes: “Liquidity is a slippery and elusive concept, in part because it encompasses a number of transactional properties of markets. These include tightness, depth, and resiliency.” In the market microstructure literature, O'Hara (1994) offers a widely accepted definition of liquidity as the ability to trade immediately without cost. In effect, the greater the degree of immediacy, the greater the market's liquidity.
Transaction costs impose frictions on the market and reduce liquidity. Collins and Fabozzi (1991) view transaction costs as the market impact of the trade execution cost that reflects the bid-ask spread plus a price concession for compensating the market maker for the risk of transacting with an informed trader. They also point out that market timing costs occur when prices react to other trading activities during a transaction. Increasing trading in the market provides more liquidity to the market. As a result, economies of scale in trading can lower both the bid-ask spread and the average transaction cost.
Locke and Venkatesh (1997) document an average quoted bid-ask spread that is higher than the average ...