The Liquidity of the Market Portfolio

The liquidity of broad claims to aggregate wealth is a crucial financial variable, both in theory and in practice. Direct measurement of this quantity has not been possible to date, leaving many first-order questions unanswered. For instance, how illiquid is the market portfolio, how much does that illiquidity change, and what drives those changes? We directly study the liquidity of the market portfolio via the price impact of order flow in the S&P 500 futures. Using identification through heteroskedasticity to address simultaneity of order flow and returns, we quantify both the level and variability of market illiquidity. Next, we construct a directly observable ex-ante, measure of illiquidity via the slope of the limit order book. From its dynamics we find that the nonflow component of return volatility de-creases liquidity, but the volatility of order flow does not; trading volume has only a transient effect on liquidity; and liquidity varies positively with order flow itself. These results point to limited risk bearing capacity, rather than asymmetric infor-mation or temporary price pressure, as a primary determinant of market illiquidity. We find no evidence that fluctuations in intermediary capital played a role in the extraordinary surge in illiquidity in late 2008