Liquidity : The third dimension in asset pricing

The purpose of this paper is to set up a clear definition of liquidity in equity markets and to develop a liquidity factor to measure liquidity, including its formula. We claim that four necessary elements in sum are sufficient to define the term liquidity. Its structure is determined by the relations between these elements. To specify our considerations, we will focus on the trading of equity products in their home market when defining liquidity and deriving its formula. However, our deliberations can be transferred equally to any other liquidity pool and to the other modules of the value chain.To underline our assumptions, we will start with some general remarks about definitions which we then apply to the term liquidity. In a next step we will develop a concept of liquidity: A general and abstract definition for the liquidity of equity markets. This is the basic starting point for the concretization and individualization of the term liquidity. It enables us to measure liquidity in concrete situations in the real world. Having reached the highest level of concretization and individualization we are now able to apply the liquidity factor λ as the measured ease to trade a certain stock. We end up with some working definitions which are core for the development and application of the formula. After these rather theoretical considerations we turn to the concrete calculation of the liquidity factor λ. We spend some thoughts on general aspects for the calculation of liquidity before we derive a concrete formula for its measurement. We analyze this liquidity factor from different angles and also take a look at related formulae before we conclude our paper with an outlook on further objects of investigation. As to the methodology of this paper we will pursue a deductive approach. We will start with some general rules on liquidity before we successively narrow the range under consideration until we draw our conclusions on liquidity for a certain stock under predefined premises. Nevertheless, the results we will obtain are equally applicable to other securities with other predefined premises: They are applicable to equity markets in general