When do low-frequency measures really measure effective spreads? Evidence from equity and foreign exchange markets

We compare low-frequency measures of effective spreads with their high-frequency counterparts. We find that some popular measures suffer from a volatility-induced bias and that volatility is the primary driver of the variation of these liquidity proxies. We show that such distortions arise when the effective spreads are small relative to volatility and illustrate the implications of using these measures in studies of illiquidity pricing and the relationship between liquidity and leverage. Our results provide novel insights into the performance and relative ranking of the low-frequency measures and can help empirical researchers chose the appropriate effective spread measures for their applications