hard · Market Microstructure
The Amihud illiquidity ratio is defined as the average of |r_t|/Vol_t (absolute return over dollar volume). A researcher finds that for a given stock, Amihud illiquidity rises sharply during a period when the bid-ask spread, depth, and price-impact coefficient are all UNCHANGED, while average daily dollar volume falls by half and absolute returns are stable. What does this episode reveal about interpreting Amihud as a liquidity measure?
- Amihud conflates price impact with volume level, so a drop in volume mechanically raises the ratio even when the true cost of trading a fixed quantity is unchanged
- Amihud correctly detected deteriorating liquidity, because lower volume always implies wider spreads and higher impact even if those were measured as flat
- The episode shows Amihud is robust, since a stable price-impact coefficient guarantees the ratio is invariant to volume by construction
- Amihud measures realized rather than effective spread, so unchanged depth and spread cannot affect it and the rise must be a data error
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