36. Market liquidity¹

Liquidity, which is integrally related to trading costs, refers to the ability of individuals to trade at reasonable prices with reasonable speed. As such, liquidity is a major determinant, along with risk and return, of a company’s share value. Unfortunately, an operational, generally accepted measure of liquidity does not exist. This entry considers the following proxy measures: the bid—ask spread, the liquidity ratio (which relates the number or value of shares traded during a brief interval to the absolute value of the percentage price change over the interval), and the variance ratio (which relates the volatility of short-term price movements to longer-term price movements). The determinants of liquidity considered are the size of the market for a stock and market structure. The paper concludes by stressing that illiquidity increases the cost of equity capital for firms, but that trading costs can be reduced and liquidity enhanced by the institution of a superior trading system.