Market Liquidity: An Elusive Variable

Equity prices depend on risk, expected return, and market liquidity. Market liquidity, however, is an elusive variable. Prevailing thinking relates primarily to revealed liquidity, e.g. posted orders. The authors propose the concept of “latent” liquidity to complement this definition, and discuss liquidity in terms of its empirical assessment, dependence on market structure, and effect on asset pricing. Regarding regulatory policy concerning market structure, the objective should be to enhance market quality, which is tantamount to liquidity provision. This should lead to extended economic benefits as one thing is widely agreed on: all financial markets would benefit from being more liquid.