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Measuring the liquidity part of volume

Serge Darolles, Gaëlle Le Fol and Gulten Mero

Journal of Banking & Finance, 2015, vol. 50, issue C, 92-105

Abstract: Based on the concept that the presence of liquidity frictions can increase the daily traded volume, we develop an extended version of the mixture of distribution hypothesis model (MDH) along the lines of Tauchen and Pitts (1983) to measure the liquidity portion of volume. Our approach relies on a structural definition of liquidity frictions arising from the theoretical framework of Grossman and Miller (1988), which explains how liquidity shocks affect the way in which information is incorporated into daily trading characteristics. In addition, we propose an econometric setup exploiting the volatility–volume relationship to filter the liquidity portion of volume and infer the presence of liquidity frictions using daily data. Finally, based on FTSE 100 stocks, we show that the extended MDH model proposed here outperforms that of Andersen (1996) and that the liquidity frictions are priced in the cross-section of stock returns.

Keywords: Volatility–volume relationship; Mixture of distribution hypothesis; Liquidity shocks; Information-based trading; Liquidity arbitrage; GMM tests (search for similar items in EconPapers)
JEL-codes: C51 C52 G12 (search for similar items in EconPapers)
Date: 2015
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Working Paper: Measuring the Liquidity Part of Volume (2015)
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