Market Liquidity as Dynamic Factors

We study market liquidity via daily close relative spreads and daily traded volumes in a sample of 426 Samp;P500 constituents recorded over the years 2004-2006, a period of quot;normalquot; liquidity conditions. We use recent results on the Generalized Dynamic Factor Model (GDFM) with block structure to provide a sound definition of unobservable market liquidity and to assess the complementarity of those two liquidity measures. The advantage of defining market liquidity as dynamic factors is that, contrary to other definitions that can be found in the literature, it tackles time dependence and commonness at the same time, without making any restrictive assumptions on the underlying data generating process. Both relative spread and volume in the dataset under study appear to be driven by the same one-dimensional common shocks, which therefore naturally qualify as the unobservable market liquidity shocks