Friday, January 18

Volume, liquidity, and liquidity risk

Interesting paper, made me go hmmm.

Timothy C. Johnson, Volume, liquidity, and liquidity risk, Journal of Financial Economics Volume 87, Issue 2, , February 2008, Pages 388-417.

Many classes of microstructure models, as well as intuition, suggest that it should be easier to trade when markets are more active. In the data, however, volume and liquidity seem unrelated over time. This paper offers an explanation for this fact based on a simple frictionless model in which liquidity reflects the average risk-bearing capacity of the economy and volume reflects the changing contribution of individuals to that average. Volume and liquidity are unrelated in the model, but volume is positively related to the variance of liquidity, or liquidity risk. Empirical evidence from the U.S. government bond and stock markets supports this new prediction.

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