Intrinsic Liquidity in Conditional Volatility Models

Until recently the liquidity of financial assets has typically been viewed as a second-order consideration. Liquidity was frequently associated with simple transaction costs that impose - temporary if any- effect on asset prices, and whose shocks could be easily diversified away. Yet the evidence- especially the recent liquidity crisis- suggests that liquidity is now a primary concern. This paper aims at disentangling market risk and liquidity risk in the context of conditional volatility models. Our approach allows the isolation of the intrisic liquidity of any asset, and thus makes it possible to deduce a liquidity risk even when volumes are not observed