hard · Market Microstructure spread-econ

Amihud's illiquidity ratio is defined as the daily average of |r_t| / V_t, where r_t is the day's return and V_t is dollar volume. An analyst notices that for a thinly traded micro-cap, Amihud illiquidity computed over a month is far HIGHER than the stock's actual round-trip transaction cost (effective spread) would suggest. Which feature of the Amihud measure best accounts for this overstatement relative to the true price-impact cost?

1. On near-zero-volume days the ratio |r_t|/V_t explodes even for tiny absolute returns, and averaging these spikes inflates the measure beyond what a marginal trade's price impact would be
2. Amihud's measure double-counts the bid-ask bounce because it is built from close-to-close returns, which already embed the full round-trip quoted spread on each trading day observed
3. Dollar volume in the denominator is effectively denominated in raw share counts for this micro-cap, so its low share price understates liquidity and biases the ratio upward across the whole sample
4. Amihud illiquidity is fundamentally a realized-spread proxy rather than a price-impact measure, so it necessarily exceeds the effective spread by the full adverse-selection component's size

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