Measuring Bond Market Liquidity: Devising A Composite Aggregate Liquidity Score

Abstract

The importance of liquidity in financial markets is emphasised strongly in the academic literature. There is more than one definition of liquidity, which can lead to confusion when attempting to measure liquidity levels. Hence liquidity is often measured through the use of proxy indicators such as the bid-offer spread. No single measure is completely satisfactory, and the use of proxy measures renders comparison across markets difficult. Our objective is to devise a composite aggregate measure of liquidity that makes use of a range of market factors, and which is applicable to any financial market. This study considers United Kingdom gilt securities during 1993–2002, a period of structural reform in the market. We devise a transparent, accessible and easy-to-implement method to measure liquidity level in a financial market, using an aggregate scoring system. This adopts a composite methodology, using components selected on the basis of their relative importance to promoting liquidity. Our research suggests that market liquidity improved in the gilt market during our observation period. Furthermore, the measurement methodology we propose may be employed by institutional investors to measure liquidity in any financial market, and enables them to make comparisons across different markets prior to making the investment decision.

TOPICS: Statistical methods, VAR and use of alternative risk measures of trading risk, exchanges/markets/clearinghouses